B - B - A - (Banking) 122 13 Banking Theory Juhb PDF

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YTISREVINUALAGAPPA
APPAGALAUNIVERSITY
B.B.A. [Banking]

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300 036 – IDUKIARA
KARAIKUDI
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122 13 NOITACUDE ECNATSIDDIRECTORATE
FO ETAROTCEOF
RIDDISTANCE EDUCATION
BANKING THEORY
I - Semester
BANKING THEORY
B.B.A. [Banking]
122 13
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ISREVINUALAGAPPA
APPAGALAUNIVERSITY
rihT eht ni )46.3:APGC( CA[Accredited
AN yb edarGwith
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BANKING THEORY
B.B.A. [Banking]
KARAIKUDI
K – 630 003
TACUDE ECNATSIDDIRECTORATE
FO ETAROTCEOF
I - Semester
ALAGAPPA UNIVERSITY
[Accredited with ‘A+’ Grade by NAAC (CGPA:3.64) in the Third Cycle
and Graded as Category–I University by MHRD-UGC]
(A State University Established by the Government of Tamil Nadu)
KARAIKUDI – 630 003
Directorate of Distance Education
B.B.A. [Banking]
I - Semester
122 13
BANKING THEORY
Reviewer
Professor of Management,
Dr. R. Perumal Directorate of Distance Education,
Alagappa University, Karaikudi
Authors:
K C Shekhar: Former Professor of Commerce, Department of Post-Graduate Studies, St. Thomas College, Trichurand
Lekshmy Shekhar: Chartered Accountant, Former Deputy General Manager, Finance, Yokogawa Blue Star - Bengaluru;
Manager SAP Global Enterprise System Support, Washington DC
Units (1.2-1.4, 2, 3, 4, 5.2, 6, 7, 8.3, 9, 10, 11, 12, 13, 14)
MC Vaish: Former Professor and Head, Department of Economics, University of Rajasthan, Jaipur
Unit (5.3-5.5)
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SYLLABI-BOOK MAPPING TABLE
Banking Theory
BLOCK I: BASIC THEORY OF BANKING

UNIT - I: Definition of Bank - Kinds of Banks - Credit Creation by Banks - Unit 1: Introduction to Banking
Balance Sheet of Banks. (Pages 1-8);
UNIT - II: Unit Banking Vs Branch Banking. Unit 2: Unit and Branch Banking
UNIT - III: Commercial Banking - Classification of Banks - Functions - Creation (Pages 9-14);
of Credit - Balance Sheet - Investment Policies - Bank Assets - Banking Unit 3: Commercial Banking
Structure - Clearing Houses. (Pages 15-36);
UNIT - IV: Reserve Bank of India - Objectives and Functions - Control of Unit 4: Reserve Bank of India
Credit by R.B.I. - Indian Money Market (Pages 37-53);
UNIT - V: Introduction to Money - Kinds, Functions and Significance - Unit 5: Introduction to Money
Demand for and Supply of Money - Monetary Standards - Gold Standard - (Pages 54-75)
Bimetallism and Paper Currency Systems - Paper Money - Money Market.
BLOCK II: INDIAN BANKING SYSTEMS

UNIT - VI: Foreign Exchanges - Exchange Market and Rates of Exchange - Unit 6: Foreign Exchange
Exchange Control. and Control
UNIT - VII: Banking Regulation Act, 1949: History; Social Control; Banking (Pages 76-104);
Regulation Act as Applicable to Banking Companies and Public Sector Banks; Unit 7: Banking Regulation
Banking Regulation Act as Applicable to Co-operative Banks. Act, 1949
UNIT - VIII: Indian Banking - Reserve Bank of India - Organisation - (Pages 105-135);
Management - Functions - NABARD - State Bank of India - Exchange Banks Unit 8: Indian Banking
- Commercial Banks - Indigenous Banks - Co-operative Banks. (Pages 136-148);
UNIT - IX: State Bank of India: Brief History; Objectives; Functions; Structure Unit 9: State Bank of India
and Organization; Working and Progress. (Pages 149-171)
BLOCK III: BANKS REGIONAL SET AND RRB

UNIT X: Regional Rural and Co-operative Banks in India: Functions; Role Unit 10: Regional Rural and
of Regional Rural and Co-operative Banks in Rural India; Progress and Cooperative Banks
Performance. in India
UNIT - XI: Place of Private Sector Banks.- Role and Functions in India (Pages 172-203);
Unit 11: Place of Private
Sector Banks
(Pages 204-208)
BLOCK IV: BANKER AND CUSTOMER SYSTEM

UNIT - XII: Bankers as Borrowers - Precautions to be taken before Opening Unit 12: Bankers as Borrowers
Accounts - Legal Significance of Fixed Deposit Receipts. (Pages 209-215);
UNIT - XIII: Definition of the Term Banker and Customer - General Relationship Unit 13: Banker and Customer:
- Special Relationship - Main Functions and Subsidiary Services Rendered Relationship
by Banker - Agency Services and General Utility Services. (Pages 216-234);
UNIT - XIV: Recent Trends in Indian Banking System Unit 14: Recent Trends in Indian
Banking System
(Pages 235-244)
CONTENTS
INTRODUCTION
BLOCK I: BASIC THEORY OF BANKING

UNIT 1 INTRODUCTION TO BANKING 1-8
1.0 Introduction
1.1 Objectives
1.2 Definition of Bank
1.3 Kinds of Banks
1.4 Credit Creation and Balance Sheet
1.5 Answers to Check Your Progress Questions
1.6 Summary
1.7 Key Words
1.8 Self Assessment Questions and Exercises
1.9 Further Readings
UNIT 2 UNIT AND BRANCH BANKING 9-14

2.0 Introduction
2.1 Objectives
2.2 Unit Banking and Branch Banking: Basics
2.4 Summary
2.5 Key Words
UNIT 3 COMMERCIAL BANKING 15-36

3.0 Introduction
3.1 Objectives
3.2 Functions of Banks
3.3 Investment Policies
3.4 Bank Assets and Structure
3.5 Clearing Houses
3.7 Summary
3.8 Key Words
UNIT 4 RESERVE BANK OF INDIA 37-53

4.0 Introduction
4.1 Objectives
4.2 Objectives and Functions of Reserve Bank of India
4.2.1 Functions
4.3 Control of Credit by RBI
4.4 Indian Money Market
4.6 Summary
4.7 Key Words
UNIT 5 INTRODUCTION TO MONEY 54-75

5.0 Introduction
5.1 Objectives
5.2 Kinds, Functions and Significance
5.3 Supply of Money
5.3.1 Demand for Money
5.4 Monetary Standards: Gold, Bimetallism and Paper Currency Systems
5.5 Money Market
5.7 Summary
5.8 Key Words
BLOCK II: INDIAN BANKING SYSTEMS

UNIT 6 FOREIGN EXCHANGE AND CONTROL 76-104
6.0 Introduction
6.1 Objectives
6.2 Foreign Exchange
6.3 Exchange Market and Rate of Exchange
6.4 Exchange Control
6.6 Summary
6.7 Key Words
UNIT 7 BANKING REGULATION 105-135

7.0 Introduction
7.1 Objectives
7.2 History, Social Control and Applicability
7.2.1 Banking Laws (Application to Cooperative Societies) Act, 1966
7.2.2 Social Control Over Banks
7.4 Summary
7.5 Key Words
UNIT 8 INDIAN BANKING 136-148
8.0 Introduction
8.1 Objectives
8.2 Reserve Bank of India: Organization, Management and Functions
8.2.1 Management and Structure
8.2.2 Major Functions of RBI
8.2.3 State Bank of India
8.2.4 Commercial and Cooperative Banks
8.2.5 Indigenous Banks
8.3 NABARD
8.5 Summary
8.6 Key Words
UNIT 9 STATE BANK OF INDIA 149-171

9.0 Introduction
9.1 Objectives
9.2 The State Bank of India: Objectives and Functions
9.2.1 Organization and Structure
9.2.2 Objectives
9.3 State Bank of India: Working and Progress
9.5 Summary
9.6 Key Words
BLOCK III: BANKS REGIONAL SET AND RRB

UNIT 10 REGIONAL RURAL AND COOPERATIVE BANKS IN INDIA 172-203
10.0 Introduction
10.1 Objectives
10.2 Functions, Role and Performance
10.2.1 Rural Cooperatives: Short-Term and Long-Term Structure
10.4 Summary
10.5 Key Words
UNIT 11 PLACE OF PRIVATE SECTOR BANKS 204-208
11.0 Introduction
11.1 Objectives
11.2 Role and Functions in India
11.4 Summary
11.5 Key Words
BLOCK IV: BANKER AND CUSTOMER SYSTEM

UNIT 12 BANKERS AS BORROWERS 209-215
12.0 Introduction
12.1 Objectives
12.2 Precautions to be taken before Opening Accounts
12.3 Significance of Fixed Deposit Receipts
12.5 Summary
12.6 Key Words
UNIT 13 BANKER AND CUSTOMER: RELATIONSHIP 216-234

13.0 Introduction
13.1 Objectives
13.2 Definitions of the Terms Banker and Customer
13.3 Relationship, Functions, Subsidiary and Agency Services
13.5 Summary
13.6 Key Words
UNIT 14 RECENT TRENDS IN INDIAN BANKING SYSTEM 235-244

14.0 Introduction
14.1 Objectives
14.2 Recent Trends: An Overview
14.4 Summary
14.5 Key Words
Introduction
INTRODUCTION
Banking in India originated in the last decades of the 18th century. The first banks
NOTES were The General Bank of India which started in 1786, and the Bank of Hindustan,
both of which are now defunct. The oldest bank in existence in India is the State
Bank of India, which originated in the Bank of Calcutta in June 1806, which almost
immediately became the Bank of Bengal. The Reserve Bank of India (RBI) is the
central banking system of India and controls the monetary policy of the rupee as
well as 426 billion (2018) of currency reserves. The institution was established on
1 April 1935 during the British Raj in accordance with the provisions of the Reserve
Bank of India Act, 1934 and plays an important part in the development strategy
of the government. In 1949, the Banking Regulation Act was enacted which
empowered the Reserve Bank of India (RBI) ‘to regulate, control, and inspect the
banks in India.’ The Banking Regulation Act also provided that no new bank or
branch of an existing bank could be opened without a license from the RBI, and
no two banks could have common directors.
Commercial Banks in India are broadly categorized into Scheduled
Commercial Banks and Unscheduled Commercial Banks. The Scheduled
Commercial Banks have been listed under the Second Schedule of the Reserve
Bank of India Act, 1934. The modern Commercial Banks in India cater to the
financial needs of different sectors.
The book is divided into fourteen units, dealing with commercial banking,
money market, banking Regulation Act 1949, innovations in banking service, foreign
exchange, banker and customer, Indian banking and Private sector banks.
The book is written in SIM (Self-Instructional Material) format for Distance
Learning and each unit starts with an Introduction and Objectives. Then, the detailed
content is presented in an understandable an organized manner. A Summary is
provided at the end of each unit for a quick revision. That is followed by a list of
Key Words. Each unit will also have Check Your Progress Questions to test the
students’ understanding of the topics covered, the answers to which are also
provided at the end of the unit. It is followed by Questions and Exercises. Each
unit also has a list of books for Further Reading.
Self-Instructional
8 Material
Introduction to Banking
BLOCK - I
BASIC THEORY OF BANKING
NOTES
UNIT 1 INTRODUCTION TO
BANKING
Structure
1.0 Introduction
1.1 Objectives
1.2 Definition of Bank
1.3 Kinds of Banks
1.4 Credit Creation and Balance Sheet
1.6 Summary
1.7 Key Words
1.0 INTRODUCTION
Banks play an inevitable role in a country’s economy. The demographics of a

country is majorly dependent on the banking structure for saving and loans. The
fact that banks play the dual role of accepting deposits and issuing loans prove the
mettle and importance of banks in a society.
The present banking structure of our country is coherent and constantly
evolving to meet the immediate needs of the population. Despite the fact that there
is a lot of pressure on the banks in the present scenario, one cannot do away with
the efficiency with which banks have been delivering their services to the people.
1.1 OBJECTIVES
After going through this unit, you will be able to:
 Learn the definition of bank
 Understand the different kinds of banks
 Discuss the process of credit creation by banks
 Know about the balance sheet of banks
Self-Instructional
Material 1
1.2 DEFINITION OF BANK
Banking plays a pivotal role in modern trade and commerce. Banks perform the
NOTES twin functions of accepting deposits from the public and making loans to needy
and deserving people in society. Deposits become liabilities and loans appear on
the assets side of their balance sheets. Banks lend money to different categories of
borrowers. The interest received on those loans becomes their primary source of
income and the interest on deposits constitutes the main item of expenditure for a
bank.
Banks in India are regulated by the Banking Regulation Act, 1949. The
repayment of deposit on demand is a necessary requirement to qualify to become
a bank.
According to the Banking Regulation Act, 1949, banking means ‘the
accepting, for the purpose of lending or investment, of deposits of money from the
public, repayable on demand or otherwise, and withdrawable by cheque, draft,
order or otherwise.’
1.3 KINDS OF BANKS
Banks in India are classified into the following categories in accordance to their
functions, which include the following:
 Central Bank
 Commercial Banks
 Development Banks
 Cooperative Banks
 Specialized Banks
Fig. 1.1 Classification of Banks in India
Self-Instructional
2 Material
Check Your Progress

1. Mention the act which regulates banks in India.
2. What is the necessary requirement to qualify to become a bank? NOTES
3. Define banking as per the Banking Regulation Act, 1949.
1.4 CREDIT CREATION AND BALANCE SHEET
Commercial banks always try to maintain their holdings of idle cash to the lowest
extent possible. In their attempt to achieve this end, they unwittingly increase the
total amount of money in circulation in the community. It, however, does not mean
that they increase the total amount of legal tender currency which is an exclusive
prerogative of the central bank.
When it is said that a banker is lending money, he is actually lending money
in the deposit credit with a right to the borrower to draw cheques against it. For
instance, let us take the case of a loan granted to a customer. Instead of paying
away the whole loan in the form of liquid cash, the bank will place the amount to
the credit of the borrower. Thus, the borrower acquires a claim against the bank,
just as a sum of money deposited by him with the bank creates a claim against the
bank. Assuming the borrower draws cheques in favour of other people, they pay
these cheques into their own banks for collection, and their deposits go up. Here
one may agree with Hartley Withers in that ‘every loan creates a deposit’. Again,
by purchasing securities or any other banking assets also a bank is adding to the
total supply of money.
When the bank buys securities, it pays for them by its own cheque. This
cheque, like a currency note issued by the central bank, is an IOU (I Owe You) of
the bank issuing it. And this is accepted by the seller of the securities because of
his faith in the ability of the bank to produce cash on demand. The seller deposits
this cheque in the very same bank or with any other bank where he has an account,
thereby creating additional deposit money. Thus, the commercial banks as a system
can and do increase the total amount of money in circulation by increasing the
purchasing power of the people through the deposit money created by them.
A close analytical study of the mechanism of banking will simplify matters
more. Let us take the case of a community where there is only one bank and
where the people are highly banking minded so that all transactions are settled
by means of cheques. Further, let us assume that total amount of legal tender
currency in circulation is 10,000 and the bank knows by experience that
Self-Instructional
Material 3
Introduction to Banking 10 per cent of its deposits as cash reserves is sufficient to meet the demands of
its customers.
Since there is only one bank in the community, people will deposit all their
money in this particular bank. The balance sheet of the bank would then be:
NOTES
Liabilities Assets
Deposits 10,000 Cash in Hand 10,000
According to our assumption, the bank would need to maintain a cash

reserve of only 10 per cent of the deposits and can safely lend the balance amount
of 9,000 to those who are in need of funds. The bank will place this amount to
the credit of the borrowers, giving them the right to operate their accounts with
cheques. Their deposits will consequently go up by this amount. The balance
sheet of the bank, then, would be:
Liabilities Assets
Deposits (original) 10,000 Cash in Hand 10,000
Deposits (i.e. credit
Balance of borrowers) 9,000 Loans to clients 9,000
19,000 19,000
These deposits, now standing to the credit of the borrowers are, as we

know, claims against the bank. As such they command a purchasing power and
hence they may be considered as good as money. Suppose the borrowers draw
cheques in favour of their creditors. The payees of these cheques will not require
liquid cash over the counter since they are highly banking minded, according to
our supposition. On the other hand, they will deposit these cheques with our
supposed single bank for collection. Here what happens is merely a transfer of the
credit balance of the borrowers to the credit of the accounts of the payees of their
cheques. In short, although the total amount of legal tender currency in circulation
is only to the order of 10,000, our bank, through the process of creating additional
deposit money, has brought into effective circulation an additional amount of
9,000, thereby raising the total supply of money from 10,000–19,000. The
power of the bank to increase the amount of money in circulation does not come
to an end here. It can further increase the supply of money.
As shown in the above balance sheet, the amount of the deposits of the
bank is now 19,000. The assumption is that the bank should maintain a cash
reserve ratio of only 10 per cent. To maintain this, the bank only needs to provide
an additional amount of 900 over and above the amount of 1,000 which it
already maintains. Even then there is a balance of 8,100 in the vaults of the
Self-Instructional
4 Material
bank which it can lend without undergoing any risk. Now the balance sheet Introduction to Banking
position would be:
Liabilities Assets
Deposits (original) 10,000 Cash in Hand 10,000 NOTES
Deposits (deposited by the
Payees of the cheques issued
by the first borrowers 9,000 Loans to Clients.
Deposits (credit balance of 9,000
Subsequent borrowers) 8,100 8,100 17,100
27,100 27,100
Here the bank has to keep an additional cash reserve of 810. The total
cash reserves increase to 2,710. Still there is a balance of loanable funds with the
bank, amounting to 7,290.
Thus, the bank can go on increasing the creation of additional money.
However, there are questions that crop up. Is it possible for the bank to increase
credit without any limit? Is the power of the bank to increase the supply of deposit
money unlimited? The answer is definitely in the negative.
Limitations on the Creation of Credit
The power of commercial banks to create credit is limited mainly by the cash
reserves which they have to hold against their deposits and the total amount of
legal tender currency issued by the central bank. Every bank has to meet the
demands of its customers to pay cash over the counter. So a working reserve of
liquid cash is always necessary for a bank.
Of course, if the people are highly banking minded, a lower cash reserve
will be sufficient. But in the case of a community where the habits are not well
developed, a higher cash reserve will be essential. In either case, a cash reserve is
necessary. This acts as a brake on the power of the banks to create credit. To
revert to the previous illustration, our supposed bank can go on creating further
and further credit money till it finds that it has no more liquid cash to maintain the
10 per cent cash reserve ratio. In other words, it is in a position to supply more
and more credit up to an additional amount of 90,000. If it wants to expand
credit still further, either there should be an additional supply of liquid cash, which
entirely is the sole prerogative of the central bank, or the cash ratio should be
lowered which can be done only at its own peril. Moreover, a minimum cash
reserve ratio is prescribed by law in most countries. Thus, a bank’s power to
create credit is limited by two factors, viz., the cash reserve ratio and the total
amount of legal tender currency.
Self-Instructional
Material 5
Introduction to Banking So far the analysis was confined to a community where there is only one
bank. This is not a realistic assumption. But admittedly, the multiplicity of banks
will not make any material alteration in the mechanism of credit creation and the
limitations on it. The banking system, taken as a whole, will be conducting its
NOTES operations on the very same lines. The only difference is that if any bank tries in an
isolated manner to expand credit more than the other banks, it will lose cash to
other banks. So in the case of a network of branches, each bank will have to keep
in step with the others whenever it is creating credit.
In conclusion, commercial banks can increase the total amount of money in
circulation through the process of credit creation. In the words of Sayers, ‘Bankers
are not merely purveyors of money, but also, in an important sense, manufacturers
of money.’
Check Your Progress

4. ‘A banker is lending money’. What does this statement actually mean?
5. How can commercial bank as a system add money in circulation?
6. Mention the two factors which limit the bank’s power to create credit.
1.5 ANSWERS TO CHECK YOUR PROGRESS

QUESTIONS
1. Banks in India are regulated by the Banking Regulation Act, 1949.

2. The repayment of deposit on demand is a necessary requirement to qualify
to become a bank.
3. According to the Banking Regulation Act, 1949, banking means ‘the
accepting, for the purpose of lending or investment, of deposits of money
from the public, repayable on demand or otherwise, and withdrawable by
cheque, draft, order or otherwise.’
4. When it is said that a banker is lending money, he is actually lending money
in the deposit credit with a right to the borrower to draw cheques against it.
5. The commercial banks as a system can and do increase the total amount of
money in circulation by increasing the purchasing power of the people through
the deposit money created by them.
6. A bank’s power to create credit is limited by two factors, viz., the cash
reserve ratio and the total amount of legal tender currency.
Self-Instructional
6 Material
1.6 SUMMARY
 Banking plays a pivotal role in modern trade and commerce.

 Banks perform the twin functions of accepting deposits from the public and NOTES
making loans to needy and deserving people in society.
 Banks lend money to different categories of borrowers. The interest received
on those loans becomes their primary source of income and the interest on
deposits constitutes the main item of expenditure for a bank.
 Banks in India are regulated by the Banking Regulation Act, 1949.
 According to the Banking Regulation Act, 1949, banking means ‘the
accepting, for the purpose of lending or investment, of deposits of money
from the public, repayable on demand or otherwise, and withdrawable by
cheque, draft, order or otherwise.’
 Banks in India are classified into Central Bank, Commercial Banks,
Development Banks, Cooperative Banks and Specialized Banks.
 When it is said that a banker is lending money, he is actually lending money
in the deposit credit with a right to the borrower to draw cheques against it.
 When the bank buys securities, it pays for them by its own cheque. This
cheque, like a currency note issued by the central bank, is an IOU (I Owe
You) of the bank issuing it.
 The power of commercial banks to create credit is limited mainly by the
cash reserves which they have to hold against their deposits and the total
amount of legal tender currency issued by the central bank.
 Commercial banks can increase the total amount of money in circulation
through the process of credit creation.
1.7 KEY WORDS
 Cheque:A cheque, or check is a document that orders a bank to pay a

specific amount of money from a person’s account to the person in whose
name the cheque has been issued.
 Liquid cash: Liquid cash represents the most fluid asset a company can
own. These items can include cash, demand deposits, time and savings
deposits, and short-term saving accounts easily converted to cash.
 Loan: A loan is money, property or other material goods that is given to
another party in exchange for future repayment of the loan value amount.
 Credit: Credit refers to the ability of a customer to obtain goods or services
before payment, based on the trust that payment will be made in the future.
Self-Instructional
Material 7
1.8 SELF ASSESSMENT QUESTIONS AND
EXERCISES
NOTES Short-Answer Questions

1. What are the two important functions performed by a bank?
2. State the definition of bank.
3. What are the different kinds of banks in India?
4. How do banks add more to the supply of money?
Long-Answer Questions
1. ‘When the bank buys securities, it pays for them by its own cheque.’ Discuss
the statement with examples.
2. How does a bank create credit? Explain.
3. What are the limitations of credit creation? Discuss.
4. What does a bank do when it buys securities? Analyse.
1.9 FURTHER READINGS
Somashekar, NT. 2009. Banking. NewAge International. New Delhi.

Goddard, John and Wilson O.S. John. 2016. Banking: A Very Short Introduction.
Oxford University Press. United Kingdom.
Parameswaran, R. 2001. Indian Banking. S. Chand Publishing. New Delhi.
Gupta, H.R. 2011. Practical Banking in India. Gyan Publishing House. New
Delhi.
Iyenger, Vijayaragavan. 2009. Introduction to Banking. Excel Books. New Delhi.
Self-Instructional
8 Material
Unit and Branch
UNIT 2 UNIT AND BRANCH Banking
BANKING
NOTES
Structure
2.0 Introduction
2.1 Objectives
2.2 Unit Banking and Branch Banking: Basics
2.4 Summary
2.5 Key Words
2.0 INTRODUCTION
In order to meet the pressing needs of people, the banking structure of India has
constantly evolved. Unlike the past when banks used to be confined to metropolitan
cities, today one can witness the presence of banks in a wide range of areas. The
focus of the banks has significantly moved towards establishing their presence in
rural areas and isolated regions. Typically, there are two types of banking systems
which are unit banking system and branch banking system. The unit banking system
is a localized system. One typical example of unit banking system is of U.S.A. On
the contrary, the branch banking system extend across regions such as the one
followed in England.
2.1 OBJECTIVES
 Understand the meaning of unit banking
 Discuss the purpose of branch banking
 Learn the advantages of unit and branch banking
 Know about the disadvantages of unit and branch banking
2.2 UNIT BANKING AND BRANCH BANKING:

BASICS
Group banking and chain banking systems, which have been referred to, are
generally found in the USA only. More important systems of banking are the unit
banking and branch banking. The USA and England may be taken as the typical
Self-Instructional
Material 9
Unit and Branch countries which follow the systems of unit banking and branch banking, respectively.
Banking
For instance, in England most part of the banking business is in the hands of four
major banks which are popularly known as ‘the Big Four’, viz., the Midland, the
Lloyds, the Barclays and the National Westminster. The branches of these banks
NOTES extend to all parts of England. In addition to England, countries like Canada,
South Africa, Australia, India, etc., follow branch banking system. In contrast to
this is the banking system of the USA, which is predominantly a localized one. In
the USA, unit banks are generally linked together by the ‘correspondent bank’
system. Under the correspondent bank system, the country banks deposit money
with the city banks and the city banks with the reserve city banks. This arrangement
helps each bank to make remittances through the correspondent.
Advantages and Disadvantages of Branch Banking and Unit Banking
The advantages of branch banking, which are the objections raised by the advocates
of branch banking against unit banking, may be summarized as follows:
 Branch banks as compared to unit banks can provide better facilities to
their customers because of the comparatively limited number of customers
per banking office and because of the efficiency achieved through large
scale operations.
 It is not necessary for any particular branch to maintain large amounts of
idle cash reserves. Whenever any help is required by any branch the
resources of the other branches can be transferred to that particular branch.
Of course, a unit bank can draw on the correspondent banks, but in the
case of branch banking the help will readily be forthcoming since it is in the
interest of the bank as a whole.
 Management can be made more efficient by proper staff selection, training
and appointment of the right person in the right place. This advantage arises
as a corollary to the economies achieved through large-scale operations.
 Industrial and geographical diversification of loan risks is possible in the
case of branch banking. Because of this even when a branch suffers a loss
through the decline of the industries in that locality, the profits earned by the
other branches will make up that loss. Whereas in the case of unit banks,
those units situated in the depressed areas may undergo heavy losses which
might be followed by a crop of bank failures.
 Branch banks increase the mobility of capital which brings uniformity of
interest rates. In order to take advantage of the increased interest rates
prevailing in any locality, banks under branch banking generally transfer the
deposits from the branches situated in those localities where demand for
money is relatively low (and consequently interest rates less) to those
branches situated in those localities where the demand for money is relatively
high (and consequently interest rates higher). In both these localities the
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10 Material
supply of money is thus brought into equilibrium with the demand and hence Unit and Branch
Banking
the interest rates tend to uniformity over the whole area served by branch
banks.
 Remittance facilities can be provided to the customers cheaply because
NOTES
inter-office indebtedness can be more easily adjusted than inter-bank
indebtedness.
 Clearing of cheques is comparatively easy since cheques deposited at a
branch can be sent to the office in the city where there is a clearing house
and then can be cleared in the customary way. But in the case of unit banks
clearing involves greater complications and greater expenses.
 Finally, it is said that branch banks give their customers the service of more
powerful and solvent banks. A branch has not only the assets of a particular
office behind it but the assets of all the offices of the bank.
Now, one may turn the attention to the objections to branch banking which
are generally raised by the unit bankers in support of the unit banking system.
These may be summarized as follows:
 The branch manager will have to get the permission of the Head Office,
which, being totally ignorant of the borrowers, may require the branch
to cover each and every loan by collateral securities, thus refusing to
lend on the personal security of the borrowers even when they are
desirable borrowers. In this respect, the unit banker is at an advantageous
position because he will have personal knowledge of the borrowers and
can easily decide which of them are desirable.
 Since the branch managers have to refer each and every loan to the
Head Office, delay and red taspism are but natural. The unit banker, on
the other hand, can use his discretion and can arrive at quick decisions.
 Branch managers are transferred too frequently and so they are liable to
be unsympathetic with local needs.
 The failure of a bank with a large number of branches spread all over
the country will have wide repercussions throughout the country. On the
other hand, the failure of a unit bank will not have generally such
countrywide effects since they carry on purely localized business.
 It is difficult to exert a very effective control over all the branches when
a bank grows beyond the optimum size. Consequently, mismanagement
on a large-scale is more likely under branch banking than under unit
banking. As a result, expenses are likely to mount high, having an adverse
effect on profits.
 Finally, it is said that market conditions are so localized that unit banking
is more suitable.
Self-Instructional
Material 11
Unit and Branch No doubt, these objections contain an element of truth. But they hardly
Banking
constitute a very serious criticism on branch banking and cannot be considered as
absolutely valid. For instance, the charge of red tapism and delay in the case of
branch banking is not a very serious one as it can easily be remedied by the use of
NOTES telephone or by giving the branch managers the discretion to lend up to fixed
amounts. Therefore, efficiency in management and effectiveness in control can
also be maintained by keeping the number of branches within limits and not allowing
the bank to grow beyond the optimum. Again, some of the objections raised
against branch banking may be considered as its advantages, when viewed from
another angle, like the example of the objection on the remoteness of the Head
Office. This will enable the branch manager to refuse a loan without straining his
personal relationship with the customer by shifting the responsibility of loan refusal
to the shoulders of the Head Office. Further, against the objection that branch
banking retards local economic development by insisting on collateral securities
against loans, it may be stated that it is always better to be on the safe side by
following a careful loan policy, and an ideal banker should never underrate the
importance of securing advances with proper collateral securities.
In conclusion, advantages weigh heavily with branch banking. That is why
countries find increasing favour with branch banking system of banking. Even in
the USA, which is known as the home of unit banking, branch banking is permitted
by law to a certain extent. 18 states permit state wide branch banking, while 17
states permit limited area branch banking. Only the remaining states specifically
prohibit branch banking. Among the leading banks of that country, the Bank of
America has branches throughout the State of California.
Check Your Progress

1. Name the banks which hold most of the banking business in England.
2. Where does the money get deposited under the correspondent banking
system?
3. Mention any one advantage of branch banks over unit banks.

QUESTIONS
1. In England most part of the banking business is in the hands of four major
banks which are popularly known as ‘the Big Four’, viz., the Midland, the
Lloyds, the Barclays and the National Westminster.
2. Under the correspondent bank system, the country banks deposit money
with the city banks and the city banks with the reserve city banks.
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3. Branch banks as compared to unit banks can provide better facilities to Unit and Branch
Banking
scale operations.
NOTES
2.4 SUMMARY
 Group banking and chain banking systems, which have been referred to,
are generally found in the USA only.
 More important systems of banking are the unit banking and branch banking.
The USA and England may be taken as the typical countries which follow
the systems of unit banking and branch banking, respectively.
 Branch banks as compared to unit banks can provide better facilities to
scale operations.
 Branch banks increase the mobility of capital which brings uniformity of
interest rates.
 Branch managers are transferred too frequently and so they are liable to be
unsympathetic with local needs.
 It is difficult to exert a very effective control over all the branches when a
bank grows beyond the optimum size. Consequently, mismanagement on a
large-scale is more likely under branch banking than under unit banking.
 Even in the USA, which is known as the home of unit banking, branch
banking is permitted by law to a certain extent.
 18 states permit state wide branch banking, while 17 states permit limited
area branch banking. Only the remaining states specifically prohibit branch
banking.
 Among the leading banks of that country, the Bank of America has branches
throughout the State of California.
2.5 KEY WORDS
 Reserves: Funds or material set aside or saved for future use are called
reserves.
 Unit banking: Unit banking refers to a bank that is a single, usually
small bank that provides financial services to its local community.
 Branch banking: Branch banking is engaging in banking activities such as
accepting deposits or making loans at facilities away from a bank’s home
office.
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Unit and Branch
Banking 2.6 SELF ASSESSMENT QUESTIONS AND
EXERCISES

1. Which systems of banking are followed in the USA and England?
2. What is the advantage of correspondent banking system followed in the
USA?
3. How are branch banks better than unit banks?
4. Which of the two banking systems, unit and branch, is more effective in
dealing with red tapism?
1. Describe the advantages of branch banking.
2. Discuss the disadvantages of unit banking.
3. ‘Industrial and geographical diversification of loan risks is possible in the
case of branch banking.’ Comment on the statement with reference to the
text.
4. Discuss the objections to branch banking raised by unit bankers.

Delhi.
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14 Material
Commercial Banking
UNIT 3 COMMERCIAL BANKING

Structure NOTES
3.0 Introduction
3.1 Objectives
3.2 Functions of Banks
3.3 Investment Policies
3.4 Bank Assets and Structure
3.5 Clearing Houses
3.7 Summary
3.8 Key Words
3.0 INTRODUCTION
The two most important functions of a commercial bank is accepting deposits and
lending loans. Commercial banks are very important for a successful economy.
Most people need loans either to buy house, vehicles or other such things. Banks
play a very crucial role in providing debts or loans to people so that they can buy
assets. The banking structure of India is very flexible which has been evolving to
satisfy the immediate needs of the people.
3.1 OBJECTIVES

 Understand the structure of commercial banking
 Discuss the classification and functions of banks
 Learn about creation of credit and balance sheet
 Know about bank assets and banking structure
3.2 FUNCTIONS OF BANKS
As we have already discussed the classification of banks and creation of credit in

the first unit, here we will discuss some other important concepts.
Functions of Commercial Banks and The Services Rendered by Them
The two essential functions of a commercial bank may best be summarized as the
borrowing and the lending of money. They borrow money by taking all kinds of
deposits. Deposits may be received on current account whereby the banker incurs Self-Instructional
Material 15
Commercial Banking the obligation to repay the money on demand. Interest is not payable on current
account deposits. When deposits are received on savings bank account as well,
the bank undertakes the obligation to repay them on demand. Interest is usually
allowed on savings bank deposits although there are usually restrictions on the
NOTES total amount that can be withdrawn and/or the number of times withdrawals are
allowed during a defined period. When deposits are received on fixed deposit
accounts, the banker incurs the obligation to repay the money together with an
agreed rate of interest after the expiry of a fixed period. When deposits are received
on deposit accounts, the banker undertakes to repay the customer together with
an agreed rate of interest in return for the right to demand from him an agreed
period of notice for withdrawals. In addition, a new banking account, which is
similar to savings bank account, known as flexi bank account has been introduced
by banks. Thus, a commercial bank mobilizes the savings of the society. This
money is then provided to those who are in need of it by granting overdrafts or
fixed loans or by discounting bills of exchange or promissory notes. In short, the
primary function of a commercial bank is that of a broker and a dealer in money.
By discharging this function efficiently and effectively, a commercial bank renders
a very valuable service to the community by increasing the productive capacity of
the country and thereby accelerating the pace of economic development. It gathers
the small savings of the people, thus reducing the quantity of idle money to the
lowest limits. Then, it combines these small holdings in amounts large enough to be
profitably employed in those enterprises where they are most called for and most
needed. Here it makes capital effective and gives industry the benefits of capital,
both of which otherwise would have remained idle. For instance, take the practice
of discounting bills of exchange. By converting future claims into present money,
the commercial bank bridges the time element between the sale and the actual
payment of money. This will enable the seller to carry on his business without any
hindrance; and the buyer will get enough time to realize the money.
Thus, a commercial bank receives deposits which it has to repay according
to its promise and makes them available to those who are really in need of them.
The bank is actually distributing its deposits between the borrowers and its own
vaults. Herein, lies the most delicate of the functions of a commercial bank.
Besides these two main functions, a commercial bank performs a variety of
other functions which may broadly be grouped under two main heads, viz., the
agency services and the general utility services.
Agency Services
A commercial bank provides a range of investment services. Customers can arrange
for dividends to be sent to their bank and paid directly into their bank accounts, or
for the bank to detach coupons from bearer bonds and present them for payment
and to act upon announcements in the press of drawn bonds, coupons payable,
etc. Orders for the purchase or sale of stock exchange securities are executed
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through the banks’ brokers who will also give their opinions on securities or lists of Commercial Banking
securities. Similarly, banks will make applications on behalf of their customers for
allotments arising from new capital issues, pay calls as they fall due and ultimately
obtain share certificates or other documents of title. On certain agreed terms, the
banks will allow their names to appear on approved prospectuses or other NOTES
documents as bankers for the issue of new capital; they will receive applications
and carry out other instructions.
A commercial bank undertakes the payment of subscriptions, premia, rent,
etc., on behalf of its customers. Similarly, it collects cheques, bills of exchange,
promissory notes, etc., on behalf of its customers. It also acts as a correspondent
or representative of its customers, other banks and financial corporations.
Most of the commercial banks have an ‘Executor and Trustee Department’.
Some may have affiliated companies to deal with this branch of business. They
aim to provide a complete range of trustee, executor or advisory services for a
small charge. The business of banks acting as trustees, executors, administrators,
etc., has continuously expanded with considerable usefulness to their customers.
By appointing a bank as an executor or trustee of his/her will, the customer secures
the advantage of continuity, avoiding to have made changes, impartiality in dealing
with beneficiaries and in the exercise of discretions and the legal and specialized
knowledge pertaining to executor and trustee services. When a person dies without
making a will, the next-of-kin can employ the bank to act as administrator and to
deal with the estate in accordance with the rules relating to intestacies. Alternatively,
if a testator makes a will but fails to appoint an executor, or if an executor is unable
or unwilling to act, the bank can usually undertake the administration with the
consent of the persons who are immediately concerned. Banks will act solely or
jointly with others in these matters, as also in the case of trustee for stocks, shares,
funds, properties or other investments. Under a declaration of trust, a bank
undertakes the supervision of investments and distribution of income; a customer’s
investments can be transferred into the bank’s name or control, thus enabling it to
act immediately upon a notice of rights issue, allotment letters, etc. Alternatively,
where it is not desired to appoint the bank as nominee, these services may still be
carried out by appointing the bank as attorney. Where business is included in an
estate or trust, a bank will provide for its management for a limited period, pending
its sale to the best advantage as a going concern or transfer to a beneficiary.
Private companies wishing to set up pension funds may appoint a bank as
custodian, trustee and investment advisor, while retaining the administration of the
scheme in the hands of the management of the fund.
Most banks will undertake the preparation of income tax returns on behalf
of their customers and claim for the recovery of overpaid tax. They also assist the
customers in checking the assessments. In addition to the usual claims involving
personal allowances and reliefs, claims are prepared on behalf of residents abroad,
minors, charities, etc.
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Commercial Banking General Utility Services
These services are those in which the bank’s position is not that of an agent for his
customer. They include the issue of credit instruments like letters of credit and
NOTES travellers’ cheques, the acceptance of bills of exchange, the safe custody of
valuables and documents, the transaction of foreign exchange business, acting as
a referee as to the respectability and financial standing of customers, providing
specialized advisory service to customers, etc.
Banker’s Drafts and Letters of Credit
By selling drafts or orders and by issuing letters of credit, circular notes, travellers’
cheques, etc., a commercial bank is discharging a very important function. A
banker’s draft is an order, addressed by one office of a bank to any other of its
branches or by any one bank to another, to pay a specified sum to the person
concerned. A ‘letter of credit’ is a document issued by a banker, authorizing some
other bank to whom it is addressed, to honour the cheques of a person named in
the document, to the extent of a stated amount in the letter and charge the same to
the account of the grantor of the letter of credit. A letter of credit includes a promise
by the issuing banker to accept all bills of exchange to the limit of credit. When the
promise to accept is conditional on the receipt of documents of title to goods, it is
called a ‘documentary letter of credit’. When the promise is unconditional, it is
called a ‘clean letter of credit’. Letters of credit may again be classified as revocable
and irrevocable. A ‘revocable letter of credit’ is one which can be cancelled at any
time by the issuing banker. But the banker will still be liable for bills negotiated
before cancellation. An ‘irrevocable letter of credit’ is one which cannot be cancelled
before the expiry of the period of its currency. ‘Circular letters of credit’ are generally
intended for travellers who may require money in different countries. They may be
divided into ‘travellers letter of credit’ and ‘guarantee letters of credit’. A ‘travellers
letter of credit’ carries the instruction of the issuing bank to its foreign agents to
honour the beneficiary’s drafts, cheques, etc., to a stated amount which it
undertakes to meet on presentation. While issuing a ‘guarantee letter of credit’,
the bank secures a guarantee for reimbursement at an agreed rate of interest, or it
may insist on sufficient security for the grant of credit. There is yet another type
which is known as ‘revolving credit’. Here the letter is so worded that the amount
of credit available automatically reverts to the original amount after the bills
negotiated under them are duly honoured.
Circular Notes, Travellers Cheques, Circular Cheques
Circular notes are cheques on the issuing banker for certain round sums in his own
currency. On the reverse side of the circular note is a letter addressed to the
agents specifying the name of the holder and referring to a letter of indication in his
hands, containing the specimen signature of the holder. The note will not be honoured
unless the letter of indication is presented. Travellers’ cheques are documents
similar to circular notes with the exception that they are not accompanied by any
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letter of indication. Circular cheques are issued by banks in certain countries to Commercial Banking
their agents abroad. These agents sell them to intending visitors to the country of
the issuing bank.
Safe Custody of Valuables NOTES
Another important service rendered by a modern commercial bank is that of
keeping in safe custody valuables such as negotiable securities, jewellery, documents
of title, wills, deed-boxes, etc. Some branches are also equipped with specially
constructed strong rooms, each containing a large number of private steel safes of
various sizes. These may be used for a small fee. Each user is provided with the
key of an individual safe and thus not only obtains protection of his/her valuables
but also retains full personal control over them. The safes are accessible at any
time during banking hours, and often longer.
Night Safes
For shopkeepers and other customers who handle large sums of money after
banking hours, ‘night safes’ are available at many banks. Night safe takes the form
of a small metal door on the outside wall of the bank, accessible from the street,
behind which there is a chute connecting with the bank’s strong room. Customers
who require this service are provided with a leather wallet, which they lock before
placing in the chute. The wallet is opened by the customer when he calls at the
bank the next day to get the contents credited to his account.
Referee as to the Respectability and Financial Status
of the Customer
Another function of great value, both to banks and businessmen, is that of the
bank acting as a referee as to the respectability and financial status of the customer.
Bank Giro
Among the services introduced by a modern commercial bank during the last
quarter of a century or so, the ‘bank giro’ and ‘credit cards’ deserve special
mention. The ‘bank giro’ is a system by which a bank customer with many payments
to make, instead of drawing a cheque for each item, may simply instruct his bank
to transfer to the bank accounts of his creditors the amount due from him. He
writes one cheque debiting his account with the total amount. Credit advices
containing the name of each creditor with the name of his bank and branch will be
cleared through the ‘credit clearing’ of the clearing house, which operates in a
similar way as for the clearing of cheques. Even non-customers of a bank may
make use of this facility for a small charge. A direct debiting service is also operated
by some banks. This service is designed to assist organizations which receive
large number of payments on a regular basis. A creditor is thereby enabled, with
the prior approval of the debtor, to claim any money due to him direct from the
debtor’s bank account. To some organizations, for example, insurance companies,
Self-Instructional
Material 19
Commercial Banking which receive, say, six equal sums on six dates in a year, the scheme is only an
extension of the standing order facility but for the public utilities and traders which
send out invoices for valuable amounts at differing times, the scheme is an entirely
new one.
NOTES
Credit Cards
A credit card is basically a payment mechanism which allows the holder of the
card to make purchases without any immediate cash payment. Credit limit is fixed
by the issuing bank and the limit is determined by the financial history as well as the
type of card. Users are issued with a card on production of which their signatures
are accepted on invoices in merchant establishments participating in the scheme.
The issuing bank makes the payment to the merchant establishment selling the
relevant goods or services. The holder to whom the card is issued, in turn,
reimburses the bank on receipt of the billing statement. Generally it is not necessary
to reimburse the bank with the entire amount on the billing statement. After making
payment of the minimum amount due every month, the balance could be staggered
over a period. Of course, outstanding balance plus any overdue will attract service
charge at a certain rate. Also, users are generally required to pay a regular
subscription for the use of the service. Different types of cards are available. The
benefits attached to the card vary according to the type of the card.
Often, the bank which issues the card will be a member of a payments
brand. For instance, VISA is a payments brand with global payments system. Its
cards are accepted at numerous locations (about 23 million merchant
establishments) all over the world. All establishments displaying VISA logo accept
VISA cards for all transactions. Of course, VISA itself does not offer cards or
financial services; it only advances new payment products and technologies on
behalf of its members.
On every card transaction conducted, the merchant establishment will give
a commission which will be shared by the issuing bank and the acquirer bank (i.e.,
the bank which approaches the merchant establishment for its acceptance of the
card). If it is a branded card, a part of the commission will go to the payments
brand. For instance, if it is a VISA card, a part of the commission will go to VISA.
Suppose Bank ‘A’ has convinced merchant establishment ‘X’ to accept VISA
cards. This means that all VISA cards will be accepted by establishment ‘X’. In
case establishment ‘X’ accepts the VISA card issued by Bank ‘B’, then the
commission will be shared by Bank ‘A’, Bank ‘B’ and VISA. Establishment ‘X’
will collect the amount due to it from Bank ‘A’ and Bank ‘A’ will collect the amount
from Bank ‘B’ (the bank which has issued the card). Bank ‘B’ will collect the
amount from the card holder. The entire transaction is routed via VISA.
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20 Material
Kisan Credit Cards and Laghu Udyami Credit Cards Commercial Banking
A Kisan Credit Card (used to be designated as ‘green card’ by some banks)

issued by Indian banks, aimed at providing adequate and timely support from the
banking system to the farmers for their cultivation needs including purchase of NOTES
inputs in a flexible and cost effective manner. More specifically, kisan credit cards
will facilitate farmers in the purchase of agricultural inputs such as seeds, fertilizers
and pesticides and to draw cash for other production and ancillary needs as many
times as they wish. Unlike the usual credit cards, kisan credit cards are issued
based on the landholding of agriculturists. As such, the provision of one-by-six
scheme (i.e., the provision requiring the holder of a credit card to furnish income
tax return) is not applicable to holders of kisan credit cards. The credit extended
in the case of a kisan credit card would be revolving cash credit and provides for
any number of drawals and repayments within the limit. The quantum of limit is
based on operational landholding, the cropping pattern and scales of finance
approved for the area. The cards are valid for three years and subject to an annual
review.
Encouraged by the kisan credit card scheme, Laghu Udyami Credit Cards
have been introduced in India for providing simplified and borrower-friendly credit
facilities to retail traders, artisans, professionals and self-employed persons, small
industrial units and small businessmen including those in the tiny sector.
Debit Cards
The main difference between credit cards and debit cards lies in the words ‘credit’
and ‘debit’. In case of a credit card, the card holder makes the cash payment at
the end of the month. On other hand, in the case of a debit card, it runs down ones
deposit account the moment the sale is made. In other words, while using a debit
card, one is using ones own money in the bank account. Thus, while making a
payment to a merchant establishment by using a debit card, it assumes the form of
a transaction between the establishment and ones bank account. Debit cards are
more readily accepted by merchant establishments since they get instant payment.
Debit cards free the card holder from carrying cash for his/her purchases. Although
debit cards are convenient in one sense, the card holder has to be extremely
careful with the card. If the card is lost or is stolen, the entire balance in the bank
account could be emptied with a single purchase by an unscrupulous person.
ATM Cards
An ATM (Automatic Teller Machine) Card is a variation of a debit card which one
can use in a cash machine by punching in ones PIN (Personal Identification Number)
for making cash withdrawals from ones bank account. ATM cards have the
advantage over debit cards in that a person other than the card holder will not be
able to use it for cash withdrawals because of the secrecy surrounding the card
Self-Instructional
Material 21
Commercial Banking holder’s Personal Identification Number. Also, most banks limit the amount of
cash that can be withdrawn on any single day.
Budget Accounts
NOTES Some banks are opening budget accounts for credit-worthy customers. The bank
guarantees to pay, for a specific charge, certain types of annual bills (e.g., fuel
bills, rates, etc.,) promptly as they become due, while repayments are spread
over a twelve-monthly period from the customer’s account.
All these money transmission services have particular regard to the
developments in computerised book-keeping which the banks in most countries
have already introduced.
EFT (Electronic Funds Transfer) Service
Another important service which is of comparatively recent origin is the Electronic
Funds Transfer (EFT) service. This is a service under which funds are transferred
electronically over the telephone, either nationally or internationally. International
funds transfers from applicant to beneficiary are made in as little as a few seconds.
The international network known as ‘SWIFT’ (Society for Worldwide Interbank
Financial Telecommunications), an organization promoted by banks and financial
institutions around the world, is utilized to facilitate the speedy transfer of funds
across international destinations without any paper work and expeditious efficiency.
SWIFT is the largest network in the world which has around 4,800 users in 130
countries. This is a path breaking technology that will ultimately pave the way for
paperless banking. In addition to the service which it renders to individual customers,
it will go a long way in curing the corporate sector’s headaches of cash management
in multiple locations.
Overseas Trading Services
Recognition of overseas trade has encouraged modern commercial banks to set
up branches specializing in the finance of foreign trade. Banks in some countries
have taken interest in export houses and factoring organizations. Assisted by banks
affiliated to them in overseas territories, they are able to provide a comprehensive
network of services for foreign banking business, and many transactions can be
carried through from the start to finish by a home bank or subsidiary. In places
where banks are not directly represented by such affiliated undertakings, they
have working arrangements with correspondents so that the banks are in a position
to undertake foreign banking business in any part of the world.
The banks provide more than just a means for the settlement of debts
between traders, both at home and abroad for the goods they buy and sell. They
are also providers of credit and enable the company to release the capital which
would otherwise be tied up in the goods exported. An outline of some of the
services provided by banks for overseas traders is given.
Self-Instructional
22 Material
For centuries, the bill of exchange has been one of the chief means of Commercial Banking
settlement in trade. Its function is to enable a seller or exporter of goods to obtain

cash as soon as possible after the dispatch of goods, and yet enable the buyer or
importer to defer payment until the goods reach him or later.
NOTES
There are many ways in which trade may be financed with bills of exchange.
Two common ways are:
1. The exporter will draw a bill of exchange on the importer, or, by
arrangement between the parties, on the importer’s bank, for the amount
of the exporter’s invoice for the goods. Shipping documents (usually the
invoice, marine insurance policy and the ‘bill of lading’ which is the
shipowner’s receipt for the goods) which will convey title to the goods
are attached to the bill of exchange. The exporter will sell (‘negotiate’ in
technical terms) the bill with the documents to a local banker. The receipt
of the documents of title along with the bill means that, in effect, goods
are in possession. Thus, the bank will be willing to pay the exporter
practically the full amount of his invoice and bill. The bank will immediately
forward the bill and the documents to its banking correspondents or
agents in the importer’s country to be presented to the importer, or the
importer’s bank as the case may be, for payment if the bill is payable on
demand , or for acceptance if the bill is a ‘term bill’.
2. The importer’s bank, at its request, will arrange for its banking
correspondents or agents in the exporter’s country to accept a term bill
drawn on them by the exporter, and to be accompanied by shipping
documents mentioned in (1) above. (Such an arrangement is an example
of ‘opening credit’ which is mentioned below). When the bill is accepted,
it will be returned to the exporter who can either keep it until the period
of the bill expires and then claim payment from the accepting bank, or,
as is more likely in practice, sell the bill to his own or other banks. The
accepting bank, upon accepting the bill, will detach the shipping
documents and send them to the importer’s bank.
If a bill is payable on demand (i.e., a ‘demand bill’), the importer, or his
bank on his behalf if the bill is drawn on that bank, has to pay the whole amount
when the bill is presented.
If the bill is drawn payable at a later date (i.e., a ‘time bill’ or a ‘term bill’),
for example three months after presentation, it is, upon presentation, accepted by
the importer if it is drawn on him, or by his bank on his behalf if it is drawn on it by
special arrangement. But the importer is not called upon to pay until the three
months are up.
Usually, the arrangement between the buyer and the seller will be that the
shipping documents which accompany the bill are to be detached upon payment
or acceptance of the bill by the importer or by a bank on his behalf. The documents
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Commercial Banking thus become available to the buyer so that he can take delivery of the goods when
the ship arrives, resell them in the ordinary way; and from the proceeds recoup
himself or his bank, or make funds available to meet the bill when it matures.
An overseas buyer may arrange through his bank in the home country to
NOTES
open a documentary credit in favour of the seller. This is an undertaking that the
bank will honour drafts drawn in accordance with the terms of credit, if accompanied
by stipulated shipping documents, insurance policies, etc., and presented not later
than the date of expiry of the credit. The terms usually cover the nature, price and
quantity of the goods, the method of shipment, the documents to be attached and
the date by which shipment must be effected. The creditor may undertake payment
of a demand draft or acceptance of a term draft. It may be expressed in home
currency or in foreign currency, this depending on the condition of sale. It may be
either revocable or irrevocable. The former may be cancelled at any time but the
latter cannot be cancelled without the consent of both the parties. Therefore, an
irrevocable credit provides much greater protection to the exporter.
If, for instance, a foreign importer has no account with an Indian bank, he
will open the credit with his local bank. The exporter may, however, prefer to
receive a corresponding advice that the credit is opened from an Indian bank.
Consequently, it is usual for the foreign bank to instruct its Indian banking
correspondent to advise the credit to the exporter. As an additional safeguard, an
Indian exporter may require his bank not only to advice but also to undertake
responsibility by adding its confirmation. This is known as a ‘confirmed credit’.
Having received the advice on shipment of the goods, the exporter must lodge the
documents within the time allowed by the credit. If the documents are in order as
stipulated in the credit, the exporter will receive immediate payment if it provides
for sight payment. If it calls for a bill drawn payable after sight, the bank will
accept the bill which will then be available for discount. If, for any reason, the
exporter is unable to present the document he must request the importer to instruct
the relevant bank to extend or amend the credit.
In case where it is not possible to arrange a documentary credit and the
arrangement is for payment to be made only when the goods have been sold, a
bank can usually undertake the dispatch of the shipping documents and arrange
the goods to be warehoused and insured in the name of a correspondent bank,
pending delivery of the goods in part or in whole to the exporter’s agent against
payment. The correspondent bank will then remit proceeds of sales as and when
they are made by the agent. Exporters who are dealing with first-class agents may
be prepared to ship their goods on open account. In such cases, the exporter
usually sends the documents directly by air mail to the consignee, who acts as his
agent for the sale of the goods. Remittances, in order to avoid the inconveniences
of collection, may be by a cheque on an Indian bank or by a telegraphic transfer.
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Information and Other Services Commercial Banking
As part of their comprehensive banking services, many banks act as a major

source of information on overseas trade in all its aspects. Some banks produce
regular bulletins on trade and economic conditions at home and abroad, and special NOTES
reports on commodities and markets. In some cases, they invite enquiries from
those wishing to extend their foreign trade, and are able through their correspondents
to furnish the names of reputable and interested dealers of goods and commodities
and to advise on the appointment of suitable agents. For businessmen travelling
abroad, letters of introduction indicating the purpose of journey undertaken, can
be issued addressed to banking correspondents in the various centres it is proposed
to visit. In this way, it is often possible to establish new avenues of business. On
request, banks obtain confidential opinions on the financial standing of companies,
firms or individuals at home or overseas for customers for the purpose of business.
Commercial banks furnish advice and information of trade, outside its scope.
If it is desired to set up a subsidiary or branch overseas(or, for an overseas company
to set up in the home country) they provide detailed information on local legal
requirements on company formation, tax requirements, exchange control and
insurance, helping to establish contact with local banking organizations.
To sum up, the services rendered by a modern commercial bank is of
inestimable value. It constitutes the very life blood of an advanced economic society.
In the words of Walter Leaf:
‘The banker is the universal arbiter of the world’s economy.’
Check Your Progress

1. What are the two essential functions of a commercial bank?
2. What are general utility services?
3. Define banker’s draft.
3.3 INVESTMENT POLICIES
Investment banks are organizations which assist business corporations and

governmental bodies to raise funds for long-term capital requirements through the
sale of shares, stocks. bonds, etc. These banks, unlike commercial banks, act
primarily as middlemen between business corporations and investors. Generally,
they purchase the entire issue of new securities of the business corporations or of
governmental bodies and re-issue them for public subscription at a higher price.
Sometimes, they may act as agents on commission basis, but as a rule they underwrite
the issue of securities.
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Commercial Banking Investment banks are classified as ‘originators’, ‘underwriters’ and ‘retailers.’
As originators, they bring out new issues of securities; as underwriters they
underwrite the issues; and as retailers they retail the securities to individual and
institutional investors. Frequently a single institution may act in all these capacities.
NOTES
The operative technique of the investment bankers may be briefly stated as
follows. The originator enters into all the preliminary negotiations with the issuing
corporation. Ordinarily, he requires detailed reports regarding the origin and history
of the issuing corporation, the nature of its products, the condition of plant and
machinery and other assets, its capital structure, the intention of the new issue,
etc., authenticated by the opinions of expert technicians and professional
accountants together with an attorney’s report regarding the legality of the issue.
On finding the details satisfactory, the originator enters into an agreement with the
issuing authority undertaking to bring out the new issue. If the issue is a large one,
the originator calls upon the other investment bankers to join him in forming an
‘Underwriting Syndicate’. The next step is to invite the smaller retailers to join
with the underwriting syndicate in order to form a selling group. Finally, the securities
are offered for public subscription. Simultaneously, the originator adopts a method
to avoid any possible glut in the market prices of these securities. Owing to the
psychological reaction of the early buyers, they may, out of their nervousness,
offer the securities for sale at very low prices in the market. In order to counter
any such reaction, the originator leaves an ‘open order’ to repurchase these securities
at a price slightly below the price at which they are offered to the public. However,
if the market for these securities becomes very weak, this ‘open order’ may
boomerang upon the originator himself resulting ultimately in the repossession of
the securities previously sold to the public. But such cases are not frequent.
An investment banker, thus, performs a highly useful service to the business
world by providing the necessary capital for long-term capital needs of industry.
He has been aptly termed as the entrepreneur of entrepreneurs. The investing
public is also benefited by the activities of the investment banker. This is because
of the independent and comprehensive analysis which he makes in order to gauge
the desirability of the securities which he proposes to underwrite. Of course,
instances are not wanting where unscrupulous investment bankers have cheated
the public, thereby damaging the goodwill of the entire investment banking system.
However, it is gratifying to note that many countries have already enacted protective
legislations providing for the prosecution of dishonest security dealers.
3.4 BANK ASSETS AND STRUCTURE
Just as in the case of any other commercial enterprise, the commercial banks
strive to earn a profit. But is profitability everything which a bank should pay
attention to? Can we justify a commercial bank in employing its funds in a risky
manner in anticipation of windfall profits? The answer is definitely in the negative.
A commercial bank is a custodian of others’ surplus funds. Therefore, while earning
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a profit, the bank should never forget the fact that it is doing business with the Commercial Banking
funds of others, which it acquires because of its credit. It has been seen that these
funds (deposits) are either repayable on demand or after the expiry of a fixed
period. In either case, the bank must be ready to meet the liabilities whenever
necessary. In other words, it means that the bank has many outstanding contracts NOTES
for the future delivery of money. In case of failure, it will suffer in its credit which is
the very basic foundation on which its business stands. Not only will it feel the
shock of such a failure, but it will also be transmitted to the other links of the
banking system, thereby precipitating nation-wide bank failures. Hence, a
commercial bank should always bear in mind that it is the guardian of a very
delicate mechanism which paves the way for future economic development and
which, if disturbed, will create monetary disequilibrium with all the evil effects
incidental thereto. Obviously, a commercial bank should take the necessary
precautions to keep its assets as liquid as possible. Now the question arises as to
what exactly is meant by the term ‘liquidity.’
By ‘liquidity’ one means the capacity to produce cash on demand. No
doubt, the most liquid asset is cash in the vaults of a bank. It is necessary for a
bank to keep a certain percentage of the deposits in the form of liquid cash as
reserve, either in its own vaults or with his bank, generally the Central Bank. But
such liquid cash does not earn anything and as such it is purely idle money, intended
to provide the necessary liquidity by meeting the immediate withdrawals of deposits.
As a rule, successful banking is dependent on the capacity of these reserves to
meet the immediate requirements. When liquidity is provided by the cash reserves
as above, a bank should invest its excess money in some assets which are liquid in
nature and at the same time which could earn an income.
‘Liquid assets’ may be explained briefly. These are which can be turned into
cash quickly and without loss, to meet the claims of the customers. But if an asset
is to be turned into cash quickly, it must be shiftable in nature. In other words, the
liquidity of an asset depends on the question of shifting it to the central bank or to
others willing to supply cash in exchange for it. For example, if a bank holds a first
class bill of exchange, among its other assets, which satisfies the eligibility rules of
the central bank, it can be rediscounted with the central bank when the bank is
short of funds. Again, a government security satisfies the quality of an ideal liquid
asset since it is in great demand in the stock exchange and as such shiftable. But it
is important to remember that liquidity implies not only shiftability but also shiftability
without loss. To take an example, the ordinary shares of an industrial enterprise
may be shiftable but only at a discount. Here shiftability is possible only at a loss
and hence it cannot be considered as an ideal banking asset.
The conclusion that one arrives at from the above analysis, is that commercial
banks, while employing their funds, should pay regard both for profitability and
liquidity. Liquidity in its turn is dependent on shiftability without loss. An important
point to be remembered in this connection is that liquidity should not be sacrificed
at the altar of profitability. At the same time no less important is it to remember that
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Commercial Banking to maintain excessive liquidity is to sacrifice earnings, without which banking
operations cannot be carried on successfully. An efficient and effective commercial
bank would, therefore, follow a via media between liquidity and profitability while
employing its funds and selecting its assets.
NOTES
Employment of Funds by Commercial Banks
Generally, following are the important items seen on the assets side of the Balance
Sheet of a commercial bank:
 Cash in hand
 Money at call and short notice
 Bills discounted
 Investments
 Loans and advances
The above items are given in the order of liquidity.
The first item appearing on the asset side of a commercial bank’s balance
sheet is ‘cash in hand’, including cash reserve at the central bank and demand
deposits with other banks. This is the most liquid of all assets. From the point of
view of profitability, a banker is tempted to minimize his cash holdings, while from
the point of view of liquidity, he is tempted to maximize his cash holdings. To
maintain more reserves than what is necessary is to impair the profits. The English
bankers usually maintain a cash ratio of 8 per cent while in India, a higher cash
ratio is desirable owing to the undeveloped and unpredictable nature of the money
market.
A banker is generally guided by experience in deciding what proportion of
his deposits in cash will enable him to meet all demands readily. In addition to the
minimum requirements indicated by experience, a wise banker must necessarily
allow for unpredictable needs. In this connection, certain important considerations
influencing the cash reserves of a banker may be pointed out.
In the first place, if the customers are highly banking minded, the need for
liquid cash will be small because in that case, depositors will seldom demand the
payment of cash and will content themselves by the transfer of rights which the
bank can do by mere book entries. Secondly, the banking habits of the customers
and the business conditions of the locality will have an important bearing on the
cash reserves. Certain businesses carried on by the depositors may make heavy
occasional demands for cash which the banker will have to meet with adequate
provision of liquid cash. Thirdly, it is also dependent on the reserves kept by other
banks of the locality. If certain banks are keeping higher amounts of cash reserves,
other banks will be compelled to increase their cash ratio in their bid for popularity.
Further the nature of the accounts and the size of average deposits also influence
cash reserves. For instance, if the accounts are of a fluctuating nature, a higher
cash reserve may be required. So also the cash reserves of a bank having only a
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few large deposits will be generally large because of the chances of heavy Commercial Banking
withdrawals. On the other hand, if the bank has a large number of small sized
deposits, the danger of large withdrawals by any individual customer will be less
and hence it need not maintain a large amount of liquid cash. Again, the presence
of a bankers’ clearing house greatly reduces the need for liquid cash to be kept by NOTES
a bank because it has only to provide for the difference between the cheques
drawn on it and the cheques drawn by it on other banks. Even this difference is
settled by mere book entries by the clearing house. Lastly, the bank has to take
into account probable receipts of cash by it and probable demands upon it, in the
near future.
Thus, the ratio of liquid cash to deposits which a banker should maintain is
dependent upon a number of considerations. It varies from place to place and
from bank to bank. Therefore, it is not possible to lay down any hard and fast rule
regarding the exact cash reserve ratio which a bank should maintain. It has to give
due consideration to the various factors discussed above and has to come to a
conclusion as to the amount of liquid cash which it should maintain. In this connection,
it may be pointed out that commercial banks, in most countries, are statutorily
required to maintain a minimum reserve of liquid cash.
Earning Assets of a Bank
The cash reserves of a bank may be strengthened by a judicious selection of
certain earning liquid assets. Among these ‘Money at Call and Short Notice’ stands
first. This item represents largely the amounts lent to the discount market and/or to
stock exchange which are recoverable either on demand or on serving a short
notice. This constitutes the second line of defence. This asset has an advantage
over ‘Cash Reserves’, the first line of defence of a commercial bank in so far as it
satisfies, to a certain extent, both the attributes of a sound banking asset, viz.,
profitability as well as liquidity. It is liquid in the sense that it is recoverable at call
or short notice; it is profitable in the sense that it earns interest.
‘Bills discounted’ is also considered as a highly earning liquid asset and is
included among the ‘money market assets.’ It is considered to liquidate itself
automatically out of the sale of the goods covered by such a bill (i.e., a first class
bill of exchange is considered to be a self liquidating paper). Again, it is readily
shiftable to the central bank (by rediscounting it with the central bank) without
much loss because of the very short length of life of such a bill. As a matter of fact,
a bill of exchange is generally of three months duration and as such the loss involved
in rediscounting it will not be very great, even when it is not shifted. All this indicates
that ‘bills discounted’ is one of the most earning liquid assets, satisfying both the
qualities of an ideal banking asset.
It is not unusual for a commercial bank to invest its funds in stock exchange
securities like government securities, semi-government securities, industrial
securities, etc. These are represented by the term ‘Investments’. They enable the
bank to obtain more earning than that afforded by ‘Loans at Call and Short Notice’
Self-Instructional
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Commercial Banking or ‘Bills Discounted’, although they are less liquid. Here the bank gives importance
not only to the safety of the investment but also to the possibility of easy conversion
into cash without loss. The principles that influence a bank in rating these securities
while selecting them are the safety of capital, easy marketability, stability of price
NOTES and stability of income. The bank should always bear in mind that in buying these
securities it is not its primary object to gain by a possible rise in the prices of these
securities. Consideration should be given to this factor only if it is satisfied with the
safety and stability of capital. Generally commercial banks prefer government
securities to the shares and stocks of joint stock companies. The reasons are
manifold. Firstly, the repayment of capital is ensured because this depends on the
creditworthiness of the whole nation, whereas in the case of an ordinary stock
exchange security, safety of capital is entirely dependent on the creditworthiness
of a single institution. Secondly, the yield from a government security is steady and
reasonable. Thirdly, they are easily saleable without causing a glut in their market
prices, whereas in the case ordinary industrial securities, sale of a large block of
shares is likely to depress their prices.
The item ‘Loans and Advances’ comes next in the order of liquidity. For all
practical purposes they are not shiftable. Of course, this is the most profitable of a
bank’s assets, and a bank’s earnings are mainly derived from these assets. As a
rule, a commercial bank will lend only for short-term commercial purposes. It is
not considered to be its duty to provide long-term loans for investment purposes.
Such loans are provided by specialized agencies such as industrial banks. The
reason advanced in support of this view is that in the case of long-term loans, the
bank will find it difficult to realize them when emergencies arise. For example, in
the case of a mortgage, the mortgaged property may cover the loan with a safe
margin. But when the bank needs liquid cash most, it may find it difficult to convert
the mortgaged property into liquid cash. Herein, lies the meaning of the oft-quoted
statement. ‘The art of banking lies in knowing the difference between a mortgage
and a bill of exchange.’ In the case of a bill of exchange, it is of a self liquidating
character and offers an ideal security for a bank’s investment for reasons already
explained.
Certain general principles may be laid down which should guide a commercial
bank when it is making loans and advances. Before granting a secured loan, it
should carefully consider the margin of safety offered by the security, possibility of
fluctuations in its vale and possibility of shiftability. In case of an unsecured loan, its
repayment entirely depends on the credit of the borrower. As such, the cardinal
principles which the bank should consider are ‘character’, ‘capacity’ and ‘capital’
(usually referred to as the three Cs) of the borrower. In either case the bank
should aim at spreading these loans as widely as possible over many industries
and localities. It is also advisable for a bank to advance moderate amounts to a
large number of customers than advance large amounts to a small number of
customers.
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In addition to the above items, certain other items also appear on the assets Commercial Banking
side of a bank balance sheet, viz., ‘Acceptances and Endorsements as per Contra’
and ‘Furniture, Premises, etc’. Among these items, the item ‘Acceptances and
Endorsements as per Contra’ refers to the amounts due from the customers on
whose behalf the bank has accepted bills of exchange. These amounts are due NOTES
from the customers and hence they are considered as assets. In a certain sense,
this item represents a liability of the bank also since the liability to honour these
obligations will fall upon the bank if the customers fail to meet them on the due
dates.
The other items such as furniture, premises, etc., are not important from the
point of view of the investment portfolio of a bank as they are the least liquid of all
the assets. Further, they are not intended for conversion into cash to meet an
emergency.
Self-Liquidating Paper Theory vs Anticipated Income Theory
Traditional banking theory favoured by the conservative bankers holds that the
earning assets of a bank should be limited to short-term self liquidating productive
loans. These include self liquidating commercial papers or short-term loans intended
to provide the current working capital, which in itself is of a self liquidating nature.
The merit of the ‘self liquidating theory’ of commercial bank loans is derived from
the fact that such loans are considered to liquidate themselves automatically out of
the sale of goods covered by such a transaction. For instance, look at the case of
a bill of exchange, a typical example of a self liquidating paper, drawn for the
purpose of purchasing raw materials. The bill is covered by a genuine commercial
transaction. And a bank is justified in giving a loan against such a paper because
such self liquidating papers automatically provide the bank with liquidity through
loan repayments. Not only that but they are also shiftable to the central bank in
times of emergencies since the central bank, being the lender of the last resort, is
willing to rediscount such self liquidating papers. The loss avoiding aspect of liquidity
is also present here because of the very short periods for which these loans are
given. Moreover, they protect the business world against inflation because of their
elastic nature to correspond with trade demands. Their volume increases as
production increases and decrease as production decreases. No wonder, the
traditional bankers heavily favoured the claims of self liquidating theorists.
The validity of the self liquidating theory, however, has been challenged by
certain modern writers. They are contend that the transaction covered by a self
liquidating paper does not by itself always guarantee the liquidity of the loan,
especially when there is an abnormal fall in the prices of those commodities covered
by the transaction. It is said that customers’ loans to provide their current working
capital are not a safe and reliable source of bank liquidity. The contention that self
liquidating commercial loans provide protection against inflation has also been
challenged by the critics. They argue that during boom periods, when the business
conditions are prosperous, the borrowers increase their loans by offering more
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Commercial Banking and more self liquidating papers. As full employment is reached, the prices increase
because of the increase in the money supply as compared to the output, introducing
inflationary tendencies in the economy. They conclude by saying that the theory of
self liquidating loans has fallen out of date. And as an alternative, they advocate a
NOTES new theory of bank liquidity, viz., ‘Anticipated Income Theory of Liquidity.’ The
origin of this theory lies in the extension of term loans by the commercial banks of
the USA for financing long-term capital needs of industry. The loans are granted
on the specific condition on the part of the borrower to conduct the financial and
other affairs in such a manner as agreed upon between him and the bank. The
loans are to be liquidated out of the anticipated earnings of the borrowing enterprise.
Whatever be the merits of such a theory, a point may be said in favour of
the traditional theory of commercial bank assets. When a bank provides short-
term self liquidating productive loans, it is fairly easy for the bank to gauge the
liquid position of its customer because of the short length covered by such loans.
In the case of long-term loans granted on the basis of anticipated incomes of such
loans, the question involved is not one of gauging the current liquidity position of
the borrower, but the future earning capacity of the borrower. This depends on
the correct assessment of a number of factors which may go wrong. Due to this,
conservative bankers still find favour with the view that it is always good commercial
banking to make short-term self liquidating productive loans.
Check Your Progress

4. Define investment banks.
5. How are investment banks classified?
3.5 CLEARING HOUSES
Let us begin with two banks, say, Bank A and Bank B. Everyday the customers of
Bank A will be receiving cheques drawn on Bank B by its customers. The customers
of Bank A will deposit these cheques with their bank for collection. The customers
of Bank B will also be receiving cheques drawn on Bank A by its customers which
they will deposit with their bank, Bank B, for collection. The simplest method for
the banks is to send their peons to the respective drawee bank and to collect cash
over the counter. This method, no doubt, appears very simple. But at the same
time, it is very cumbersome and expensive. Both the banks will have to keep a
large amount of legal tender currency to meet the cheques drawn on each. This
affects the profit earning capacity of both the banks and hence their efficiency. At
the end of the day, each bank would find that it had paid a certain amount of cash
to the other and had received a certain amount of cash from the other. So, it would
be much better if the accounts between these two banks were settled as at the end
of each working day on the principle of setting off a debt which one owes to
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another by a claim against him and paying the difference in cash. Where there are Commercial Banking
many banks, business will be easily facilitated if this principle is extended so that
the cross obligations are set off through a central organization. ‘Clearing house’ is
such a central organization.
NOTES
A clearing house may be defined as an organization of various banks
constituted for the purpose of offsetting inter-bank indebtedness arising from the
transfer of deposits by a customer of a particular bank to another bank.
The mechanism of offsetting inter-bank indebtedness through a clearing house
operates as follows. Officials representing various banks meet at a common place,
the clearing house, everyday. Each representative then delivers cheques to the
others and other claims which his bank holds against them. So he also receives the
claims from the others which their respective banks hold against his bank. Cheques
and other documents dishonoured will be returned to the representative of the
respective bank. The various amounts of receipts and deliveries are added up and
a balance is struck therein. The final settlement is effected by the supervisor of the
clearing house by transferring the balance kept at the central bank by these various
clearing banks.
The advantages which a clearing house confers on society are manifold. It
prevents the waste and cost involved in collecting each and every cheque and
claim which a bank holds against another across the counter with all the danger of
loss in transit incumbent upon it. Great economy is also achieved in the employment
of liquid cash by settling the difference by simple transfer of credit from one account
to another, thereby minimizing the necessity of holding large idle cash balances.
Check Your Progress

6. What are the important items seen on the asset side of the Balance Sheet
of a commercial bank?
7. Define liquidity.

QUESTIONS
1. The two essential functions of a commercial bank may best be summarized

as the borrowing and the lending of money.
2. General utility services are those in which the bank’s position is not that of
an agent for his customer.
3. A banker’s draft is an order, addressed by one office of a bank to any other
of its branches or by any one bank to another, to pay a specified sum to the
person concerned.
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Commercial Banking 4. Investment banks are organizations which assist business corporations and
governmental bodies to raise funds for long-term capital requirements through
the sale of shares, stocks, bonds etc.
5. Investment banks are classified as ‘originators’, ‘underwriters’ and ‘retailers.’
NOTES
6. The important items seen on the asset side of the Balance Sheet of a
commercial bank are cash in hand, money at call and short notice, bills
discounted, investments and loans and advances.
7. By ‘liquidity’ one means the capacity to produce cash on demand. No
doubt, the most liquid asset is cash in the vaults of a bank.
3.7 SUMMARY
 The two essential functions of a commercial bank may best be summarized

as the borrowing and the lending of money.
 Deposits may be received on current account whereby the banker incurs
the obligation to repay the money on demand. Interest is not payable on
current account deposits.
 A commercial bank receives deposits which it has to repay according to its
promise and makes them available to those who are really in need of them.
 A commercial bank provides a range of investment services. Customers
can arrange for dividends to be sent to their bank and paid directly into
their bank accounts, or for the bank to detach coupons from bearer bonds
and present them for payment and to act upon announcements in the press
of drawn bonds, coupons payable, etc.
 General utility services are those in which the bank’s position is not that of
an agent for his customer.
 A Kisan Credit Card (used to be designated as ‘green card’ by some banks)
issued by Indian banks, aimed at providing adequate and timely support
from the banking system to the farmers for their cultivation needs including
purchase of inputs in a flexible and cost effective manner.
 Among the services introduced by a modern commercial bank during the
last quarter of a century or so, the ‘bank giro’ and ‘credit cards’ deserve
special mention.
 The ‘bank giro’ is a system by which a bank customer with many payments
to make, instead of drawing a cheque for each item, may simply instruct his
bank to transfer to the bank accounts of his creditors the amount due from
him.
 The main difference between credit cards and debit cards lies in the words
‘credit’ and ‘debit’. In case of a credit card, the card holder makes the cash
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payment at the end of the month. On other hand, in the case of a debit card, Commercial Banking
it runs down ones deposit account the moment the sale is made.
 Recognition of overseas trade has encouraged modern commercial banks
to set up branches specializing in the finance of foreign trade.
NOTES
 As part of their comprehensive banking services, many banks act as a major
source of information on overseas trade in all its aspects.
 Investment banks are organizations which assist business corporations and
governmental bodies to raise funds for long-term capital requirements through
the sale of shares, stocks. bonds, etc.
 By ‘liquidity’ one means the capacity to produce cash on demand. No
doubt, the most liquid asset is cash in the vaults of a bank.
 ‘Liquid assets’ may be explained briefly. These are which can be turned
into cash quickly and without loss, to meet the claims of the customers.
 The cash reserves of a bank may be strengthened by a judicious selection
of certain earning liquid assets. Among these ‘Money at Call and Short
Notice’ stands first.
3.8 KEY WORDS
 Asset: An asset is a resource with economic value that an individual,

corporation or country owns or controls with the expectation that it will
provide a future benefit.
 Investment: In an economic sense, an investment is the purchase of goods
that are not consumed today but are used in the future to create wealth.
 ATM: An automated teller machine (ATM) is an electronic banking outlet
that allows customers to complete basic transactions without the aid of a
branch representative or teller.
 Balance sheet: A balance sheet is a statement of the assets, liabilities, and
capital of a business or other organization at a particular point in time, detailing
the balance of income and expenditure over the preceding period.

EXERCISES
Short-Answer Questions
1. What are the functions of a commercial bank?
2. Write a short note on:
a. Agency services
b. General utility services
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Commercial Banking 3. What was the main objective of Kisan Credit Card?
4. What is the difference between debit and credit card?
5. Mention the two ways by which trade may be financed with bills of exchange.
NOTES Long-Answer Questions
1. What are the major investment policies? Discuss.
2. Discuss the general structure and methods of commercial banking.
3. Differentiate between self-liquidating paper theory and anticipated income
theory.
4. What do you understand by clearing house system? Explain.
5. ‘The cash reserves of a bank may be strengthened by a judicious selection
of certain earning liquid assets’. Comment on the statement with reference
to the text.

Delhi.
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Reserve Bank of India
UNIT 4 RESERVE BANK OF INDIA

Structure NOTES
4.0 Introduction
4.1 Objectives
4.2 Objectives and Functions of Reserve Bank of India
4.2.1 Functions
4.3 Control of Credit by RBI
4.4 Indian Money Market
4.6 Summary
4.7 Key Words
4.0 INTRODUCTION
The Reserve Bank of India plays a very crucial role when it comes to supervising
Indian economy and other banks. The RBI performs all the typical functions of a
central bank. The main function performed by RBI is to regulate the monetary
mechanism comprising of the currency, banking and credit systems of the country.
The RBI has the monopoly to issue notes and has a lot of other powers over the
banking system.
4.1 OBJECTIVES

 Understand the objectives of Reserve Bank of India
 Discuss the functions of Reserve Bank of India
 Learn about the control of credit by Reserve Bank of India
 Describe the Indian money market
4.2 OBJECTIVES AND FUNCTIONS OF RESERVE

BANK OF INDIA
The preamble to the Reserve Bank of India Act, 1934, lays down the object of
the RBI to be ‘to regulate the issue of bank notes and the keeping of reserve with
a view to securing monetary stability in British India and generally to operate the
currency and credit system of the country to its advantage’. The financial system
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Reserve Bank of India of India, before the establishment of the RBI, had been utterly inadequate mainly
because of the dual control of currency by the government and of credit by the
Imperial Bank. The Hilton Young Commission pointed out the inherent weakness
of a system in which the control of currency and credit is in the hands of two
NOTES distinct authorities, whose policies may be widely divergent and in which the
currency and banking services are controlled and managed separately from one
another. Under the circumstances, the necessity of a single institution regulating
the financial policy from the point of view of the economic development of the
nation as a whole was keenly felt, and the RBI was constituted mainly with this
object in view.
Secondly, according to Paragraph 32 of the introduction to White Paper on
Indian Constitutional Reforms, the proposal for transfer of responsibility at the
Centre from British to Indian hands was made dependent on the condition that a
Reserve Bank, free from political influence, be established and be in successful
operations. It was a ‘fundamental condition of the success of the constitution that
no room should be left for doubts as to the ability of India to maintain her financial
stability and credit, both at home and abroad’.
Thirdly, the inadequacy of the Imperial Bank of India in controlling the money
market was patent, because of the lack of confidence of other joint-stock banks
on the Imperial Bank. The success of a central banking institution depends on the
confidence which it inspires on the member banks and the influence which it
exercises on them. But the Imperial Bank, which was acting as the central bank,
was for all practical purposes a commercial bank competing with other joint-
stock banks. Under these circumstances, it was decided to establish a Reserve
Bank with the object of discharging purely central banking functions and thereby
initiating a fresh start in the field of Indian central banking.
4.2.1 Functions
The RBI performs all the typical functions of a central bank. Its main function is to
regulate the monetary mechanism comprising of the currency, banking and credit
systems of the country. For this, the Bank is given the monopoly of note issue and
has wide powers over the banking system. Another important function of the Bank
is to conduct the banking and financial operations of the government. The Bank
discharges certain other functions like maintaining the external value of the rupee,
collection and publication of monetary and financial information, etc. The range of
functions of the Bank has come to be steadily enlarged with the task of economic
development assuming new urgency and dimensions. Implementation of appropriate
monetary policies, no doubt, remains its most important function. At the same
time, the Bank is taking an active part in fostering an adequate banking structure
capable of meeting the needs of trade, industry, agriculture and commerce.
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Check Your Progress

1. What is the objective of the preamble of the Reserve Bank of India?
2. What is the main function of the Reserve Bank of India? NOTES
3. What does ‘Direct Action’imply?
4.3 CONTROL OF CREDIT BY RBI
Besides quantitative controls discussed above, the RBI may resort to qualitative
restrictions to make effective its monetary policy measures.
Under the Banking Regulation Act, 1949, the RBI is vested with powers to
control the entire banking system. In pursuance of Section 21 of the Act, the RBI
may give directions to banking companies with regard to their lending policies,
which they are bound to comply with. The section runs as follows:
1. Where the Reserve Bank is satisfied that it is necessary or expedient in
the public interest so to do, it may determine the policy in relation to
advances to be followed by banking companies generally or by any
banking company in particular and when the policy has been so
determined, all banking companies or the particular company concerned,
as the case may be, shall be bound to follow the policy so determined.
2. Without prejudice to the generality of the power vested in the Reserve
Bank under sub section (1), the Reserve Bank may give directions to
banking companies, either generally or to any banking company or group
of banking companies in particular, as to the purpose for which advances
may or may not be made, the margins to be maintained in respect of
secured advances and the rates of interest to be charged on advances,
and each banking company shall be bound to comply with any directions
as so given.
Again,
1. Where the Reserve Bank is satisfied that:
(a) in the national interest or
(b) to prevent the affairs of any banking company being conducted
in a manner detrimental to the interests of depositors or in a
manner prejudicial to the interests of the banking company or
(c) to secure the proper management of any banking company
generally.
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Reserve Bank of India It is necessary to issue directions to banking companies generally or to
any banking company in particular, it may, from time to time, issue such
directions as it deems fit, and the banking companies or the banking
company, as the case may be, shall be bound to comply with such
NOTES directions.
2. The Reserve Bank may, on representation made to it or on its own
motion, Modify or cancel any directive issued under sub section (1),
and in so modifying or cancelling any directive may impose such
conditions as it thinks fit, subject to which the modification or cancellation
shall have effect.
Further, under Section 36 (1) (a) of the RBI Act, the RBI is empowered to
caution or prohibit banking companies generally, or any banking company in
particular against entering into any particular transaction or class of transactions. It
may call for periodical as well as ad hoc returns and in the public interest may also
publish such information as it deems fit.
Implementation of Selective Credit Controls
In order to enforce the policy of selective credit controls, the RBI used to issue
directives to scheduled banks since the beginning of the Second Five Year Plan.
The first such directive was issued on 17 May 1956, to all scheduled banks not to
increase any credit limit they had already sanctioned and not to issue any fresh
credit limit against rice and paddy in excess of 50,000 to any party. In September,
this control was further extended to cover bank advances against other foodgrains,
gram and other pulses, and cotton manufactures. Since then, the Bank continued
to issue directives; some were by way of replacement or modification of previous
ones and dome by way of extension of control measures to new sectors.
Objective of Selective Credit Controls
By and large, selective credit controls are employed for the purpose of controlling
inflationary tendencies which appear owing to an increase in the total amount of
money in circulation through an over expansion of bank credit. But in a developing
country like India, they are primarily intended to prevent the anti-social use of
credit, which is associated with the speculative hoarding of stocks of strategic
commodities like foodgrains, and to push down prices or at least to check an
unwarranted increase in their prices. The Bank Rate policy, open market operations
and variable reserve ratio system, which are employed in controlling the quantity
of credit, are not effective in controlling the quality of credit and canalizing its flow
into those lines where they are most called for and most needed, whereas selective
credit controls are effective in controlling the quality of lending and investment
operations of the banks and in restricting credit against particular commodities.
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Salient Features of Selective Credit Controls Reserve Bank of India
The policy of the RBI, while instituting selective credit controls, had been one of
flexibility. In other words, the directives were promptly withdrawn when
circumstances no longer needed their continuance. For instance, the Bank, while NOTES
maintaining the broad framework of controls regulating advances against foodgrains
by banks, had made from time to time suitable modifications to the structure of
control to meet the needs of the changing situations. In other words, there was no
rigid formula for the Bank while instituting selective credit controls. On the other
hand, the measures had been essentially flexible so that they were modified
according to the developing circumstances.
Another salient feature of the control technique had been the endeavour of
the Bank to ensure that the measures did not hamper production.
The Bank had also been careful to make the necessary modifications in the
controls according to the circumstances prevailing in different areas.
Limitations of Selective Controls
The success of selective controls in arresting upward trends in prices does not
depend on the availability of bank credit alone, but also on a variety of other
factors including aggregate and individual demand and supply. It is unequivocally
admitted that monetary techniques are no panacea for curing all ills in the economy
caused by the scarcity of particular commodities in relation to their demand. In
India, shortage of supply has always been one of the important factors contributing
to hectic movements in prices.
Another limitation of this monetary technique arises from the fact that in so
far as stocks of commodities are self-financed or privately financed, the role of
bank finance is negligible.
Above all, it is a necessary pre-requisite for successful employment of the
control measures that there should be an effective machinery for the preparation
of the directives according to the peculiar circumstances of each commodity and
for the monitoring of these measures.
Moral Suasion and Credit Rationing
‘Moral Suasion’ implies persuasion of banks to follow certain lines of policies,
impressing upon them the necessity to do so. There is no element of compulsion in
this persuasion and as such the efficacy of this measure depends on the active
cooperation of banks and their goodwill to fall in line with the advices of the RBI.
That is why certain quarters have expressed doubts about the success of this
instrument of monetary policy. However, the success which the RBI could achieve
has been somewhat encouraging. A brief discussion of the activities of the Bank in
this direction is, it is hoped, not out of place in this context.
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Reserve Bank of India After the devaluation of the rupee, as speculative activities were feared, the
banks were advised to restrict their advances to genuine trade requirements and
not to grant accommodation for any speculative purposes. During the recent years,
the Governor of the RBI advises informally the commercial banks to follow the
NOTES policy measures generally. The effect which these advices invoked has been, by
and large, satisfactory; if not spectacular. The Bank’s activities in this direction are
facilitated by the concentration of resources in the hands of a few big banks which
enables the Bank officials to have frequent informal consultations with the officials
of these big banks and achieve satisfactory results.
‘Direct Action’implies the refusal of the RBI to extend rediscounting facilities
and other financial accommodation to banks following unsound banking principles,
or to grant further accommodation to banks whose capital and reserves are
considered inadequate. The Bank is not resorting to this weapon very often but
cases of wilful and persistent violations of the rules could be met with the sharp
blades of direct action with which the Bank is armoured.
4.4 INDIAN MONEY MARKET
The important constituents of the Indian Money Market are the Reserve Bank of
India, the State Bank of India and its subsidiaries, the nationalized banks, the
banks in the private sector, the development banks like the IFC, SFCs, IDBI,
etc., the functional banks, the foreign banks, the NBFCs, the cooperative banks,
the indigenous bankers and the money lenders. Presently let us have a bird’s eye
view of the general characteristics and the defects of the Indian Money Market.
Commercial Bills
Commercial bills are trade bills accepted by commercial banks. They include
both inland bills and foreign bills. Discounting commercial bills at a prescribed
discount rate is one of the methods adopted by banks for providing credit to
customers. The bank will receive the face value of such bills from the drawees
concerned. In the meanwhile if the bank is in need of funds, the same can be
rediscounted in the commercial bill rediscount market at the market related
rediscount rate. The eligibility criteria prescribed by the Reserve Bank of India for
rediscounting commercial bills, inter alia, are that such bills should arise out of
genuine commercial transactions evidencing sale of goods and the maturity date of
the bills should not exceed 90 days from the date of rediscounting. In order to
eliminate movement of papers and to facilitate multiple rediscounting, the Reserve
Bank of India has introduced ‘Derivative Usance Promissory Notes’ backed by
such eligible bills for required amounts and usance period up to 90 days. Stamp
duty is not applicable in the case of such promissory notes. This has simplified and
streamlined bill rediscounting by institutions in the secondary money market. Since
such instruments are negotiable instruments, they are a good security for investment.
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They are also liquid in the sense that they are transferable by endorsement and Reserve Bank of India
delivery.
Hundis
These are short term credit instruments. They refer to indigenous bills of exchange NOTES
generally drawn in vernacular languages and under various circumstances.
Treasury Bills
These are promissory notes of short-term maturity issued by the Union Government
to meet its short-term financial needs. Government promises to pay a stated amount
at the expiry of a stated period from the date of issue. There are 14, 91, 182 and
364 days Treasury Bills which are issued at a discount to the face value. On
maturity, the holder is paid the face value. They are issued for a minimum value of
25,000 and multiples thereof. Individuals, firms, companies, corporate bodies,
trusts and institutions can purchase them. These bills are eligible securities for SLR
purposes.
Treasury Bills are auctioned by means of either ‘multiple price auction’ system
(which is otherwise known as ‘french auction system’) or ‘uniform price auction
system’ (which is otherwise known as ‘dutch auction system’). Under multiple
price auction system, successful bidders pay their own bid prices. In more clear
terms, after receiving written bids at various levels of yield expectations, a certain
yield is decided as the cut-off rate of the security concerned. Bidders (i.e., auction
participants) who bid at yield levels lower than the yield determined as cut-off get
100 per cent allotment although at a premium which is equal to the yield differential
expressed in rupee terms. This yield differential is the difference between the cut-
off yield and the yield at which the bid is made. Those bids at yield levels higher
than that determined as cut-off yield are rejected entirely. Since November 6,
1998, 91-days Treasury Bills are auctioned by means of uniform price auction.
After determination of the market related cut-off rate, allotment is made to all the
bidders at a uniform price.
Certificates of Deposit (CDs) and Commercial Papers (CPs)
In order to give greater flexibility to investors in the deployment of their short-term
surplus funds, new money market instruments such as Certificates of Deposit (CDs)
and Commercial Papers (CPs) were introduced during 1989–90.
Certificate of Deposit (CD)
A Certificate of Deposit (CD) is a fixed-deposit option offered by banks. It is
primarily a short-term investment since the Reserve Bank of India guidelines on
the issue of CDs stipulate specifically that the maturity period of a CD should not
be less than 7 days and not more than one year from the date of issue. It is a
money market instrument which is highly liquid since an investor can sell it to
another investor. Higher returns are available on this form of investment as
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Reserve Bank of India compared to conventional savings accounts. CDs are a secure form of investment.
The investor in a CD receives a certificate wherein the details relating to the CD
such as duration of the deposit, date of maturity, etc are clearly stated.
In India, CDs are introduced in 1989. Guidelines for the issue of CDs are
NOTES
presently governed by various directives issued by the Reserve Bank of India, as
amended from time to time. Important features of the guidelines are briefly explained
below:
 Certificate of deposit (CD) is a negotiable instrument and issued in
dematerialised form or as a Usance Promissory Note against money
deposited at the bank.
 CDs can be issued by scheduled commercial banks (excluding regional
rural banks and local area banks).
 Banks have the freedom to issue CDs depending on their funding
requirements.
 Minimum amount of a CD should be 1,00,000, i.e., the minimum
deposit which could be accepted from a single investor should not be
less than 1,00,000, and in multiples of 1,00,000 thereafter.
 CDs can be issued to individuals, corporations, companies, trusts, funds,
associations, etc.
 CDs can be issued to non-residents, but only on non-repatriable basis,
which should be clearly stated on the certificate. Such CDs cannot be
endorsed to another non-resident Indian in the secondary market.
 The maturity period of CDs issued by banks should not be less than 7
days and not more than one year from the date of issue.
 CDs may be issued at a discount on face value like zero coupon bonds.
Banks are also allowed to issue CDs on floating rate basis provided the
methodology of compiling the floating rate is objective, transparent and
market-based. The issuing bank is freed to determine the discount/
coupon rate. The interest rate on floating rate CDs has to be reset
periodically in accordance with a pre-determined formula which indicates
the spread over a transparent benchmark. The investor should be clearly
informed of the same.
 CDs in physical form are freely transferable by endorsement and delivery.
CDs in demat form can be transferred according to the procedure
applicable to other demat securities.
 There is no lock-in period for CDs.
 Banks are not permitted to grant loans against the collateral of CDs.
Also, they cannot buy-back their own CDs before maturity. The Reserve
Bank of India may relax these restrictions for temporary periods through
a notification.
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Commercial Papers (CPs) Reserve Bank of India
These are unsecured debts of corporates. They are issued at a discount to the
face value in the form of promissory notes and are redeemable at par. Only
corporate with tangible net worth and working capital (fund based) limits of not NOTES
less than 4 crore each and credit rating of at least P2/A2/PP2/Ind D2 or higher
from any approved rating agency and is more than 2 months old of the date of
issue of CP are allowed to issue CPs. They are issued for maturities between 15
days and less than one year from the date of issue and are issued in multiples of 5
lakhs. Prior approval of the Reserve Bank of India is not necessary for the issue of
CPs and underwriting the issue is not mandatory. They are subject to stamp duty.
The issuing entity bears all expenses for the issue such as dealers’ fees, rating
agency fee and charges for provision of stand-by facilities. The objective of
introducing CPs was to release the pressure on bank funds for small and medium
sized borrowers and allowing top rated companies to borrow directly from
borrowers. The market for CDs and CPs is not very deep.
Commercial Bills
Commercial bills are trade bills accepted by commercial banks. Discounting
commercial bills at a prescribed discount rate is one of the methods adopted by
banks for providing credit to customers. The bank will receive the face value of
such bills from the drawees concerned. In the meanwhile if the bank is in need of
funds, the same can be rediscounted in the commercial bill rediscount market at
the market related rediscount rate. The eligibility criteria prescribed by the Reserve
Bank of India for rediscounting commercial bills, inter alia, are that such bills should
arise out of genuine commercial transactions evidencing sale of goods and the
maturity date of the bills should not exceed 90 days from the date of rediscounting.
In order to eliminate movement of papers and to facilitate multiple rediscounting,
the Reserve Bank of India has introduced ‘Derivative Usance Promissory Notes’
backed by such eligible bills for required amounts and usance period up to 90
days. Stamp duty is not applicable in the case of such promissory notes. This has
simplified and streamlined bill rediscounting by institutions in the secondary money
market. Since such instruments are negotiable instruments, they are a good security
for investment. They are also liquid in the sense that they are transferable by
endorsement and delivery.
Ready Forward Contracts (Repos)
These are money market instruments which assist in collateralized short-term
borrowing and lending through sale/purchase operations in debt instruments. In a
repo transaction, holders sell securities to an investor with an agreement to
repurchase them at an agreed price at a future date. In a reverse repo transaction,
securities are purchased with an agreement to sell them at an agreed price at a
future date. Thus it can be considered as a combination of securities trading involving
a purchase sand sale transaction and money market operation involving lending
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Reserve Bank of India and borrowing. Borrowing and lending rate for use of the money during the
intervening period is the repo rate. Internationally repos are used extensively in
money market operations. Although in India repos were initially discouraged by
laying down severe restrictions on their use, subsequently repo trading has been
NOTES permitted to be resumed. All dated government securities are eligible for repo
trading in the repo market. With a view to making the repo market an equilibrating
force between the money market and the government securities market, the Reserve
Bank of India gradually allowed repo transactions in all government securities and
Treasury Bills. In order to broaden the repo market, government securities, public
sector undertakings, banks and private corporate securities have been made eligible
for repos.
Money Market Mutual Funds (MMMFs)
With a view to providing additional short-term avenues to individual investors and
to bring money market instruments within their reach, a scheme of Money Market
Mutual Funds (MMMFs) was introduced by the Reserve Bank of India in April
1992. In order to make the scheme more flexible and thereby attractive to banks
and financial institutions and also to provide greater liquidity and depth to the
money market, certain changes were made in early 1996 in the scheme of MMMFs
by bringing them on par with all mutual funds by allowing investments by corporate
and others. Lock-in period was reduced from 45 days to 15 days. Again, during
1999 – 2000, a number of policy measures were undertaken essentially to provide
greater flexibility in the operations of the mutual fund sector.
Resources mobilized from MMMFs are required to be invested in call money,
CDs, CPs, commercial bills, Treasury Bills and government dated securities with
unexpired maturity up to one year. SEBI revises the guidelines on MMMFs from
time to time.
Dichotomy of the Indian Money Market
There is a clear demarcation of the Indian Money Market into two sectors, viz.,
the organized sector and the unorganized sector. The organized sector is composed
of the Reserve Bank of India, the State Bank of India and its subsidiaries, the
nationalized banks, the banks in the private sector, the development banks, the
functional banks, the foreign banks, the registered NBFCs and the exchange banks.
The unorganized sector is composed of the indigenous bankers and the
moneylenders and the unregistered NBFCs. The cooperative banks may be
considered as a middle sector between the organized and the unorganized sectors.
There is little coordination and cooperation between these sectors. This makes
the uniform and effective implementation of monetary policy by the Reserve Bank
of India in these sectors difficult.
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Lack of Cooperation and Coordination between the Various Sectors Reserve Bank of India
of the Money Market

Till the establishment of the Reserve Bank of India in 1935, the erstwhile Imperial
Bank of India was acting as the central bank of the country. At the same time, the NOTES
Imperial Bank was also acting as a commercial bank. This naturally weakened the
role of the Imperial Bank as a bankers’ bank and as a lender of the last resort. The
foreign banks stand in a class by themselves. The indigenous bankers, the
moneylenders and the unregistered NBFCs are not connected with the organized
sector of the money market.
Lack of Control by the Central Bank over the Unorganized Sector of
the Money Market
The indigenous bankers and the money lenders occupy a prominent position in the
money-lending business in the rural areas. No clear-cut distinction is made between
short-term lending and long-term lending or between the purposes of loans. They
hesitate to come under the control of the Reserve Bank of India. This naturally
loosens the control of the Reserve Bank over the money market. Of course, the
authorities are currently taking an active interest to control the activities of the
NBFCs.
Unhealthy Competition
Unhealthy competition exists not only between the organised and the unorganised
sector, but also among the members of these sectors individually.. The relationship
between the various segments of the money market is not cordial; they are loosely
connected with each other. In general, they follow separatist tendencies. For
instance, the public sector banks and the private sector banks look down each
other as rivals. Unhealthy competition also exists between Indian joint stock banks
and foreign banks.
Multiplicity in Interest Rates
In countries with developed money markets, the rates of interest prevailing over
the entire money market will not vary very much. But in the case of the Indian
Money Market, the rates of interest charged by the various institutions not only
vary but also they vary from season to season. For instance, the rates of interest
charged by the indigenous bankers or moneylenders do not bear any comparison
with the rates of interest charged by the commercial banks. Even in the case of
commercial banks, the rates of interest are not uniform. This limits the efficacy of
the monetary policy of the Reserve Bank of India. Immobility of funds from one
place to another could be considered as one of the important reasons for this
multiplicity in interest rates which, in turn, is, by and large, owing to the credit
immobility as a result of inadequate, expensive and time-consuming means of money
transfer. Multiplicity of interest rates affect adversely the smooth and effective
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Reserve Bank of India functioning of the money market. Of course, the recent steps taken by the Reserve
Bank of India to remedy this defect, which are detailed in the section ‘Payment
and Settlement System’ in the Chapter ‘Reserve Bank of India’ are noteworthy.
NOTES Seasonal Stringency of Funds

During the busy season from November to June seasonal shortage of funds is
experienced. On the other hand, during the slack season from June to November
accumulation of idle funds is experienced. Of course, credit situation on the basis
of seasonality is no longer much meaningful because of the introduction of quarterly
credit budgeting within the framework of annual credit budget. The essence of the
new budgeting system is to have an annual perspective demand for and supply of
funds so as to bring about a meaningful correction between projected output increase
and supply of credit.
Absence of a Well-developed Bill Market
The existence of a well organised and properly developed bill market is a pre-
requisite for the proper and efficient functioning of a money market. The reasons
for the absence of a well-developed bill market in the Indian money market and
the attempts taken by the authorities to popularize the bill habit have already been
referred to. In spite of all this, even now the bill market remains undeveloped. The
short-term bills form a much smaller proportion of the bank finance in India as
compared to that in other countries with well developed money markets. To remedy
the shortcomings of the bill market in India, suggestions are often made by various
quarters for the establishment of Acceptance Houses and Discount Houses which
were instrumental in the development of an organized bill market in the London
Money Market. While accepting the validity of this statement, we should be aware
of the impracticability of building-up London style money markets in quite
improbable places. As observed by A F W Plumptre, The need of developing
countries is not for the trappings of financial maturity, but for institutions much
close to the economic and political grass-roots. Indeed, with the pressing need to
allocate very scarce capital with highly urgent uses, the establishment and
development of financial markets may actually lead to a diversion and wastage of
capital. In this connection, the setting-up of the Discount and Finance House of
India Limited in 1988, referred to earlier, has been a step in the right direction. It
is hoped that this would go a long way towards the development of a secondary
market in treasury bills, commercial bills and other money market instruments.
Absence of Specialized Financial Institutions
Till recently, the Indian Money Market had been conspicuous by the absence of
specialized financial institutions carrying out specialized jobs in their respective
fields. It is gratifying to note that this is no longer the case although scope still exists
for the establishment of more specialized institutions of this type.
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Inadequate Banking Facilities Reserve Bank of India
Inadequate banking facilities and the lop-sided branch expansion programme of

the commercial banks had been pointed out in the past as an important defect of
the Indian Money Market. Although much yet remains to be done, these problems NOTES
have been tackled successfully to a large extent through the planned branch
expansion programme and the establishment of the Regional Rural Banks, especially
after the nationalization of the banks.
Capital Shortage
There is a general shortage of capital in the Indian money market, i.e., capital
available in the money market is insufficient to meet the needs of industry and
trade. Low saving capacity of the people, lack of developed banking habits among
the people and inadequate banking facilities especially in the rural sector are the
main reasons for this shortage of capital.
Lack of an all-India Money Market
Indian money market is divided into small segments mostly catering to the local
financial needs. Thus it has not been organised into a single integrated all-India
money market. For instance, there is little contact between the money markets in
the metropolitan cities and those in small cities and towns.
Summary
Money market does not refer to any specific place where money is lent or
borrowed. It is a mechanism through which short-term funds are loaned or
borrowed and through which a large part of the financial transactions of a country
or of the world are cleared.
The major items dealt with in a money market are trade bills, bankers’
acceptances, treasury bills, short dated government securities, commercial papers
and hundis.
The important sectors of a money market are call loan market, acceptances
market, bill market or discount market and collateral loan market.
The importance of a money market stems from the various functions it
performs in the overall interest of the economic development of the country.
Existence of an effective and efficient central bank, well organized commercial
banking system, specialized sectors, free flow of funds between the various sub-
markets, adequate facilities for transfer of funds, uniformity in interest rates,
availability of ample funds, availability of ample short-term credit instruments,
sensitiveness to internal and external events and existence of specialized financial
institutions are the important features of a developed money market.
Items dealt within the Indian Money Market are Commercial Bills, Hundis,
Treasury Bills, Certificates of Deposit (CDs) and Commercial Papers (CPs), Ready
Forward Contracts (Repos) and Money Market Mutual Funds (MMMFs). Self-Instructional
Material 49
Reserve Bank of India The important constituents of the Indian Money Market are the Reserve
Bank of India, the commercial banks, the development banks, the foreign banks,
the non-banking financial companies, the cooperative banks, the indigenous bankers
and the money lenders.
NOTES
General characteristics and defects of the Indian Money Market include
dichotomy, unhealthy competition lack of cooperation and coordination between
various sectors, lack of control by the central bank over the unorganized sector,
seasonal stringency of funds, absence of a well-developed bill market, absence of
specialized financial institutions and inadequate banking facilities, capital shortage
and lack of an all-India money market.
Check Your Progress

4. Define hundis.
5. What is a Certificate of Deposit (CD)?
6. What are the powers assigned to RBI under the Banking Regulation Act,
1949?

QUESTIONS
1. The preamble to the Reserve Bank of India Act, 1934, lays down the object
of the RBI to be ‘to regulate the issue of bank notes and the keeping of
reserve with a view to securing monetary stability in British India and
generally to operate the currency and credit system of the country to its
advantage’.
2. The main function of Reserve Bank of India is to regulate the monetary
mechanism comprising of the currency, banking and credit systems of the
country.
3. ‘Direct Action’implies the refusal of the RBI to extend rediscounting facilities
and other financial accommodation to banks following unsound banking
principles, or to grant further accommodation to banks whose capital and
reserves are considered inadequate.
4. Hundis are short term credit instruments. They refer to indigenous bills of
exchange generally drawn in vernacular languages and under various
circumstances.
5. A Certificate of Deposit (CD) is a fixed-deposit option offered by banks. It
is primarily a short-term investment since the Reserve Bank of India
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50 Material
guidelines on the issue of CDs stipulate specifically that the maturity period Reserve Bank of India
of a CD should not be less than 7 days and not more than one year from the
date of issue.
6. Under the Banking Regulation Act, 1949, the RBI is vested with powers to
NOTES
control the entire banking system.
4.6 SUMMARY
 The preamble to the Reserve Bank of India Act, 1934, lays down the object
of the RBI to be ‘to regulate the issue of bank notes and the keeping of
reserve with a view to securing monetary stability in British India and
generally to operate the currency and credit system of the country to its
advantage’.
 The financial system of India, before the establishment of the RBI, had been
utterly inadequate mainly because of the dual control of currency by the
government and of credit by the Imperial Bank.
 The RBI performs all the typical functions of a central bank. Its main function
is to regulate the monetary mechanism comprising of the currency, banking
and credit systems of the country.
 Another important function of the Bank is to conduct the banking and financial
operations of the government.
 Besides quantitative controls discussed above, the RBI may resort to
qualitative restrictions to make effective its monetary policy measures.
 Under the Banking Regulation Act, 1949, the RBI is vested with powers to
control the entire banking system. In pursuance of Section 21 of the Act,
the RBI may give directions to banking companies with regard to their lending
policies, which they are bound to comply with.
 In order to enforce the policy of selective credit controls, the RBI used to
issue directives to scheduled banks since the beginning of the Second Five
Year Plan.
 The policy of the RBI, while instituting selective credit controls, had been
one of flexibility. In other words, the directives were promptly withdrawn
when circumstances no longer needed their continuance.
 ‘Moral Suasion’ implies persuasion of banks to follow certain lines of policies,
impressing upon them the necessity to do so.
 After the devaluation of the rupee, as speculative activities were feared, the
banks were advised to restrict their advances to genuine trade requirements
and not to grant accommodation for any speculative purposes.
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Reserve Bank of India  The important constituents of the Indian Money Market are the Reserve
Bank of India, the State Bank of India and its subsidiaries, the nationalized
banks, the banks in the private sector, the development banks like the IFC,
SFCs, IDBI, etc., the functional banks, the foreign banks, the NBFCs, the
NOTES cooperative banks, the indigenous bankers and the money lenders.
 Commercial bills are trade bills accepted by commercial banks. They include
both inland bills and foreign bills.
 Commercial bills are trade bills accepted by commercial banks. Discounting
commercial bills at a prescribed discount rate is one of the methods adopted
by banks for providing credit to customers.
4.7 KEY WORDS
 Bill: Bill refers to a printed or written statement of the money owed for
goods or services.
 Lenders: Lenders refer to someone or something that lends money,
especially a large financial organization such as a bank.
 Cooperative bank: A bank that holds deposits, makes loans and provides
other financial services tocooperatives and member-owned organizations
is called cooperative bank.

EXERCISES
1. What are the objectives of the Reserve Bank of India?
2. Write a short note on the major functions performed by RBI.
3. What are the salient features of selective credit controls?
4. Mention the important features of guidelines for the issue of CDs.
5. What do you understand by commercial papers?
1. Analyse the role of the Reserve Bank of India in the Indian economy.
2. Discuss the important constituents of Indian money market.
3. What are the important features of the guidelines for the issue of CDs?
Discuss.
4. Discuss Ready Forward Contracts and Money Moarket Mutual Funds in
detail.
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Goddard, John and Wilson O.S. John. 2016. Banking: A Very Short Introduction. NOTES
Delhi.
Self-Instructional
Material 53
Introduction to Money
UNIT 5 INTRODUCTION TO
MONEY
NOTES
Structure
5.0 Introduction
5.1 Objectives
5.2 Kinds, Functions and Significance
5.3 Supply of Money
5.4 Monetary Standards: Gold, Bimetallism and Paper Currency Systems
5.5 Money Market
5.7 Summary
5.8 Key Words
5.0 INTRODUCTION
The term ‘Money Market’ does not refer to any specific place where money is
lent or borrowed. As a matter of fact, it is a mechanism through which short-term
funds are loaned or borrowed and through which a large part of the financial
transactions of a particular country or of the world are cleared. Although money
market does not refer to any specific place, it may be located in or associated with
a particular place or geographical locality where short-term funds from an entire
region or country or countries are attracted. Mumbai Money Market is a typical
example. It not only serves Mumbai but also the whole of India in borrowing and
lending short-term funds. There are also a few money markets which are
international in character, e.g., London Money Market. It serves several countries
of the world. New York Money Market is another example.
5.1 OBJECTIVES

 Discuss the kinds, functions and significance of money
 Understand the demand for and supply of money
 Describe monetary standards and gold standard
 Explain bimetallism and paper currency systems
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5.2 KINDS, FUNCTIONS AND SIGNIFICANCE
A ‘Money Market’ is a mechanism which makes it possible for borrowers and

lenders to come together. Essentially it refers to a market for short-term funds. It NOTES
meets the short-term requirements of the borrowers and provides liquidity of cash
to the lenders. In the words of Crowther, money market is the name given to the
various firms and institutions that deal in various grades of near money. According
to Madden and Nadler, … a money market is a mechanism through which
short-term loans are loaned and borrowed and through which a large part of
the financial transactions of a particular country or of the world are cleared….
A money market is distinct from but supplementary to the commercial
banking system. The importance of the money market for the nation does not
solely lie on its size. It lies rather in its liquidity, in the capacity for furnishing cash to
any part of the country at a few hours’ notice. What a bank balance is to the
individual, the money market is to the country’s credit system.
As explained in detail later, a money market is not homogenous in character.
It consists of several sectors or sub markets such as ‘call loan market’, ‘bill market’
or ‘discount market’, ‘acceptance market’, ‘collateral loan market’, etc. That is
why Crowther describes a money market as the various firms and institutions that
deal in various grades of near money.
As in the case of any form of market, the question of supply of and demand
for the items dealt with arises in the case of a money market also. The items dealt
with in a money market, in general terms, are described as ‘short-term funds’.
Their supply comes from lenders comprising of the central bank, the commercial
banks and other financial institutions. Their demand comes from the borrowers
comprising of the government, the business houses, the commercial banks, the
stock exchange dealers and private individuals.
Items Dealt within a Money Market
The major short term credit instruments dealt with in a money market include
trade bills, bankers acceptances, treasury bills, short dated government securities,
commercial papers, certificates of deposits and money market mutual funds. A
description of these items is given in the section ‘Items Dealt within the Indian
Money Market’ under ‘Indian Money Market’. Reader’s attention is invited to
that section.
Composition of the Money Market
As mentioned earlier, a money market consists of several sectors or sub markets,
each specializing in a particular type of lending. The important sectors are:
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Introduction to Money Call Money Market
This is the sub market specializing in call loans which are sometimes referred to as
‘loans at call and short notice’. These are the extreme form of short-term loans.
NOTES They are granted for overnight use or for 24 hours or a maximum of seven days.
They can be recalled on demand or at the shortest possible notice. Normally,
collateral securities are not insisted for these loans. In India, this sector of the
money market provides facilities for inter-bank lending. In UK, such loans are
provided by the banks to bill brokers and discount houses and in the US, to the
stock brokers and stock exchange dealers.
Acceptance Market
This is the sub market specializing in the acceptance of bills of exchange on behalf
of the customers. Acceptance Houses in the London Money Market provide an
example of institutions specializing in this business. Commercial banks also accept
bills of exchange on behalf of their customers. Although both inland and foreign
bills are accepted like this, the service rendered by the acceptance market is
especially important in the case of foreign bills. The exporter may not know the
creditworthiness of the importer. As such it is only natural that the exporter usually
insists that the bill should be accepted by a commercial bank or by an institution of
repute on behalf of the importer. Once the bill is accepted in this manner, it is
easier for the same to be discounted.
Bill Market (Discount Market)
This is another sector of the money market specializing in the discounting of short-
term commercial bills and treasury bills. In the London Money Market, the Discount
Houses specialize in this field. As a matter of fact, English commercial banks do
not undertake the discounting of commercial bills. Instead, they get these bills
from the Discount Houses according to their maturity needs. With the decline in
the total volume of commercial bills, the Discount Houses turned their attention to
the treasury bills and short-dated government securities also. In most other
countries, discounting of commercial bills is considered to be a subsidiary function
of the commercial banks. In India, the establishment of the Discount and Finance
House of India Limited in 1988 has been an important step towards the
development of an active discount market.
The discount market provides valuable services to the commercial banks,
the trading community and to the government. It imparts greater flexibility to the
commercial banks in their funds management. To the trading community, it facilitates
the financing of home and foreign trade by its operations in commercial bills. As
for the government, it creates a market for treasury bills and short-dated government
securities.
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Collateral Loan Market Introduction to Money
This sector of the money market specializes in the granting of short-term loans
against collateral securities. Such loans are usually granted by the commercial
banks to stock exchange dealers and brokers. Business houses also avail of short- NOTES
term loans against the security of goods, documents of title to goods, stock exchange
securities, etc.
Importance of the Money Market
The importance of a properly organized and well developed money market stems
from the various functions it performs in the overall interest of the economic
development of the country. These functions may be summarized as under :
Influences the Capital Market
Indirectly money market influences the development of the capital market. This is
because conditions in the money market influence the short-term rate of interest
which, in turn, influence the rate of interest in the long-term capital as well as the
resource mobilization in the capital market. Thus development of capital market
depends upon the development of capital money market.
Develops Trade and Industry
An important source of financing trade and industry is the money market. Through
discounting operations of bills and commercial papers, the money market finances
the short-term working capital requirements of trade and industry and facilitates
their development. It also protects many industrial units from turning sick. In other
words, money market plays a key role in financing both national as well as
international trade. Commercial finance is made available through bills of exchange
which are discounted by the bill market. Long-term loans are also necessary for
industries. This is provided in the capital market. Long-term interest rates in the
capital market are influenced by the short-term interest rates in the money market.
Thus money market indirectly assists industry through its link with and influence on
long-term capital market.
Bridges the time Element Between the Sale and Actual Payment
of Money
As an extension to the above point, by discounting bills and commercial papers,
the money market bridges the time element between the sale and the actual payment
of money. This enables the seller to carry on his/her business without any hindrance.
At the same time, the buyer gets enough time to realize the money from the sale of
the goods covered by the bills. Thus by discharging this function efficiently, the
money market helps the industrial and commercial sector to meet its working
capital requirements.
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Introduction to Money Helps in the Proper Allocation of Resources
Money market exercises an equilibrating influence on the demand for and supply
of loanable funds. The savings in the community are converted into investment
NOTES which results in the proper allocation of resources in the economy.
Facilitates Economic Growth
A well organized and properly developed money market safeguards the liquidity
and safety of financial assets. This facilitates economic growth.
Reduces Disparities in Interest Rates
By effecting quick and efficient transfer of funds as between the various regions
served by the money market, it helps to achieve uniformity in interest rates. In any
case, violent fluctuations in interest rates are avoided.
Acts as an Outlet for the Excess Short-term Funds of
Commercial Banks
The call loan market, the bill market and the collateral loan market are the main
outlets for the commercial banks to invest their excess short-term funds in a
profitable manner without impairing the liquidity of these funds. In case the banks
are in need of fundsat any time, they can meet this requirement by recalling their
short-term loans from the money market. Also, the money market assists the
commercial banks to earn profit by investing their surplus funds by purchasing
Treasury Bills and short dated government securities. These short-term credit
instruments are not only safe but also highly liquid in that they can easily be converted
into cash at short notice. Thus the commercial banks gain immensely by
economizing on their cash balances and at the same time meeting the demands for
any large withdrawals of their customers. Additionally, it enables them to meet
their statutory requirements of cash reserve ratio (CRR) and statutory liquidity
ratio (SLR) by making use of the money market mechanism.
Guides Policies of the Central Bank
Changes in the short-term rates of interest prevailing in various sectors of the
money market act as good indicators to the central bank in assessing the monetary
and credit conditions prevailing in the economy. This will help the central bank to
shape the monetary and credit policies according to the developing circumstances.
The Central Bank absorbs excess short-[term liquidity through the sale of Treasury
Bills and injects liquidity through the purchase of Treasury Bills. Thus the central
bank regulates the flow of money in order to promote economic growth with
stability.
Makes Policies of the Central Bank Effective
The various policy measures initiated by the central bank will have their first impact
on the different sub-markets of the money market. The sub-markets generally
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58 Material
react quickly to these measures. Such reactions will be transmitted to the other Introduction to Money
sectors of the economy. Thus, the link between the central bank and the economy
in general is established through the money market.
Features of a Developed Money Market NOTES
Existence of an Efficient and Effective Central Bank
The central bank of the country is the leader of the money market. It has a pivotal
role. The entire money market operations will be controlled by making funds
available depending upon the economic cycles. As such the existence of an efficient
and effective central bank which is capable of guiding, directing, regulating and
controlling the various sectors of the money market is an essential feature of a
developed money market. It formulates an appropriate monetary policy to meet
the needs of the money market, influences the supply of money in step with the
changing requirements of the economy and comes to the rescue of the banking
system by granting funds through rediscounting operations of eligible securities.
Well Organized and Developed Commercial Banking System
The commercial banks can rightly be considered as the nucleus of the whole money
market. As such a developed money market will have a well organized and properly
integrated commercial banking system capable of meeting the genuine short-term
credit needs of the economy. The policy of the commercial banks in relation to
loans and advances will have an impact on the money market. The commercial
banks act as a connecting link between the central bank and the various sectors of
the money market because of their close relation with the central bank.
Existence of Sub-markets
In a developed money market there will be well organized sub-markets, each
specializing in a particular type of financial asset. The larger the number of sub-
markets, the broader and more developed will be the structure of the money
market. Commercial paper market, bankers acceptance market, certificates of
deposit market, Treasury Bills market, Federal funds market, repurchase agreement
market, etc which are found in the New York Money Market are examples of
such sub-markets. The various sub-markets together make a coherent money
market.
Integration of Sub-markets
As an extension of the above point, there will be perfect integration among various
sub-markets. Their functioning will be interdependent. Flow of funds from one
sub-market to another and the activities of a particular sub-market will influence
the activities of other sub-markets also. There will be free and unhindered flow of
funds as between the various sub-markets. In each sub-market there will be
reasonable and healthy competition. In other words, in a developed money market
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Introduction to Money there will be a large number of borrowers, lenders and dealers. That way each
sub-market will be active enough to achieve the purpose of its existence.
Uniformity in Interest Rates
NOTES In a developed money market rates of interest prevailing in different parts of the
money market will not vary very much. Thus comparative uniformity in different
parts of the country is a characteristic feature of a developed money market.
Availability of Ample Funds
A developed money marker will have at its disposal ample funds to carry on the
numerous dealings in various sub-markets without any hindrance.
Availability of Sufficient Short-term Credit Instruments
A developed money market will have adequate supply of a variety oif short-term
credit instruments such as trade bills, promissory notes, Treasury Bills, short dated
government securities, etc.
Sensitiveness to Internal and External Events
A developed money market will be highly sensitive to the economic and political
developments at home and abroad. Such a money market will attract funds from
abroad. It will also attract borrowers, lenders and dealers of other countries to
participate in the activities of the money market in the country. Favourable
conditions for foreign investment, absence of discrimination against foreign firms
and stable political conditions are some of the other important factors which facilitate
development of the money market in the country.
Existence of Specialized Financial Institutions
This is yet another feature of a developed money market. Specialised financial
institutions like the Export-Import Bank will find a place in a developed money
market. Such institutions specialize in particular types of assets. They assist in
increasing the efficiency of the money market and making it more competitive.
The acceptance houses which specialize in accepting bills of exchange and the
discount houses which specialize in discounting bills which are found in the London
Money Market are typical examples.
Developed Industrial System
A highly developed industrial system is a necessary pre-requisite for a developed
money market. Then only will it be possible for the money market to function
smoothly and achieve the basis purpose of its existence.
Stability of Prices
The effective functioning of a developed money market will result in comparative
stability of prices all over the country.
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Check Your Progress

1. What does ‘Money Market’ system refer to?
2. What does money market consist of? NOTES
5.3 SUPPLY OF MONEY
In the literature on monetary theory while the analysis of the demand for money—
-motives for holding cash balances—has been the main focus of economists’
attention, study of the supply of money has received relatively scant attention. For
one thing, the factors influencing the demand for money have been assumed as not
influencing the supply of money with the result that in the monetary theory, the
supply of money and the demand for money have remained separate and mutually
exclusive. The classical economists and the quantity theorists believed that the
important factors affecting the supply of money did not affect the demand for
money. In this connection, the views of Milton Friedman-—one of the leading
monetarists—are worth repeating. According to Milton Friedman, the quantity
theorist.... holds that there are important factors affecting the supply of money that
do not affect the demand for money... A stable demand function is useful precisely
in order to trace out the effect of changes in supply, which means that it is useful
only if supply is affected by at least some factors other than those regarded as
affecting demand.’Although Milton Friedman recognizes that the conditions affecting
the demand for money do influence the supply of money, all the same he states that
‘it seems useful to regard the nominal quantity of money as determined primarily
by conditions of supply, and the real quantity of money and the income velocity of
money as determined primarily by conditions of demand.’
Secondly, the supply of money has been considered as an exogenous variable,
being autonomously determined by the monetary authority whose policy actions
were largely non-responsive to the monetary needs of the economy. In other words,
the supply of money did not change in response to changes in the demand for it,
i.e., in response to changes in the economy’s monetary requirements as the economy
expanded or shrank. Don Patinkin has succinctly expressed it in the words
mentioned in the following page.
‘....in most discussions of monetary theory the nominal quantity of
money supplied is taken as an exogenous variable. But though we
continuously shy away from this fact in our theoretical work, we do
nevertheless know that in the real world this is not the case for money
is largely the creature of a banking system which responds to such
endogenous variables as the rate of interest, the wages of clerks, etc.
How then can we take account of these responses? And in particular,
is there a limit to the extent to which endogenous influences can be
assumed to operate? Conversely, must a determinate monetary system
necessarily retain some exogenous element.’
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Introduction to Money In the lines above, Don Patinkin has pointed out to the tradition of treating
the money supply as an exogenous variable. He, however, holds that the
endogenous variables exert their influence on the supply of money no less than do
the exogenous variables. In fact, Don Patinkin has praised Gurley and Shaw for
NOTES their penetrating study in which the authors have focussed on the influence of the
endogenous variables on the supply of money which has traditionally been treated
as an exogenous variable. As a matter of fact, interest rate is a strategic endogenous
variable which influences both the demand for and the supply of money in the
economy.
Under a full-fledged gold-coin standard, with either gold coins actually in
circulation or with banks keeping 100 per cent reserves against the full-bodied
representative money circulating in the economy, the banks are virtually powerless
to create the credit money. Consequently, the total money supply (M) would
comprise the gold coins minted by the monetary authority. However, even under
these restrictive conditions the public could influence the money supply to suit the
total needs of the economy by influencing–by increasing or decreasing the rate (V)
per time unit each coin circulated in the economy as the medium of transactions.
This naturally gives the total money supply as a product of the total high-powered
money M issued by the monetary authority and its transactions velocity V, i.e.,
MV. However, in a monetary system operating under a fractional reserves system
the banking system acquires the power to influence significantly the total money
supply in the economy by creating deposit money since every rupee of legal reserve
is a high-powered money in the sense that each rupee of reserves can support
several rupees of the derived bank deposits. Apart from the power of banks to
create credit, the public also influences the size of total bank deposits by influencing
the velocity of these bank-created deposits. Consequently, the total money supply
becomes the sum of the high-powered money issued by the monetary authority
multiplied by its velocity, i.e., MV and the bank-created deposit money M multiplied
by its velocity V, i.e., MV. In short, the total money supply in circulation in the
economy equals M V + MV.
Even if it is assumed that the supply of high-powered money (M) is
exogenously determined by the monetary authority whose actions are non-
responsive to economy’s needs (demand for money), the other components of
the money supply being endogenously determined (V and V are directly under
public’s control while the M is responsive to the interest rate changes and other
endogenous variables), the total money supply cannot be treated entirely as an
exogenous variable without inviting the legitimate criticism.
There is an overwhelming evidence that lends support to the hypothesis
concerning the commercial banks’ supply response to interest rate changes albeit
the exact nature of this response is not yet fully understood. A rise (fall) in the
interest rate, ceteris paribus, induces the commercial banks in the economy to
increase (decrease) their total credit. Consequently, it is not correct to assume
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that the total stock of money in the economy is determined exogenously only by Introduction to Money
the monetary authority without any reference to credit creation by the commercial
banking system.
As opposed to the views of the monetarists who argue that the total supply
NOTES
of money is primarily determined exogenously by the monetary authority—central
bank—are the views of the Keynesians who hold that the total money supply in
the economy is largely determined endogenously in response to the economy’s
needs. Led by Professor Nicholas Kaldor, the Keynesians have strongly asserted
their point and have argued the issue ad nauseam. To cite as a case, A B Cramp
hammers the point that ‘it is strongly arguable that, in practice, whatever, textbook
theory says, the quantity of money has been largely determined “endogenously”
by the demands/needs of the economy, rather than “exogenously” imposed on the
economy by the Central Bank as the monetarist doctrine presumes.’
The views of the monetarists are sharply opposed to those of the Keynesians.
This divergence of the two views is due to the fact that while the monetarists stress
the power of the central bank to control the issue of money to an extent that it can
ignore the monetary needs of the economy (it should, however, be noted that in
the final analysis, the total stock of money depends on the willingness of the central
bank to acquire assets), the Keynesians believe in a responsible central bank
which responds to the monetery requirements of the economy that are strictly
determined by the portfolio analysis. A critical evaluation of the two approaches to
the supply of money leads us to the conclusion that neither of these two approaches
is entirely correct and the truth lies somewhere in between. In fact, the supply of
money in the economy depends on (a) the degree of responsibility of the central
bank; and (b) the judgement, effectiveness and scientific authority with which the
central bank performs its functions. It also depends on the supply response of the
commercial banks to the interest rate changes which might be initiated by the
central bank itself as a necessary part of its monetary policy action in order to
influence the total money supply in the economy.
Position in India
In India, the Reserve Bank of India (RBI) has adopted the narrow and broad
concepts of the money supply. According to the narrow approach, the money
supply (M1) comprises of the, (i) currency with the public (C), and (ii) demand
deposits with the banks (D) while the major components of the broad money
supply (M3) comprise the (i) currency with the public, (ii) demand, deposits with
the banks, and (iii) time deposits with the banks. Major sources of supply of M3
comprise the (i) net RBI credit to government; (ii) other banks’ credit to government;
(iii) other banks’ commercial credit; and (iv) net foreign exchange assets of the
banking sector.
Besides the familiar concepts of M1 and M3 pertaining to the supply of
money, the second working group set up by the RBI in 1977 propounded the
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Introduction to Money money supply concepts of M2 and M4. The concept of the M2 comprises M1 and
deposits in post office saving banks while the concept of M4 comprises the M3
and total deposists of post office savings organization (excluding national savings
certificates). In other words,
NOTES
M1 = currency with public (C) + demand deposits with banks (D):
M2 = M1 + deposits with post office savings banks;
M3 = M1 + time deposits with banks: and
M4 = M3 + deposits with post office savings organization.
The Reserve Bank of India publishes the statistics relating to the major
components and major sources of supply of the M1 and M3 fortnightly.
Currency with the public is the most important component of money supply
as it can be used directly, instantly and without any restrictions to make the payment.
Its close substitutes—demand deposits in banks, traveller’s cheques issued by
banks and other known non-banking firms, like the American Express Company
are also included in the definition of money.
Included in the broad money supply are the time or fixed deposits in the
banks, funds in the savings banks accounts in the banks; bank drafts, commercial
papers, short-term treasury deposits credit cards issued by the banks, etc., are
also included in the concept of broad money supply as these can be converted in
to money proper at short notice.
In any analysis of the demand for money, the basic question is: why do people
demand money? People demand money because money performs the basic
important functions of the medium of exchange and the store of value in the economy.
There are three principal approaches to the demand for money, namely the classical
approach, the Keynesian approach and the post-Keynesian or modern approach.
We may now discuss each one of these three approaches or theories of the demand
for money beginning with the classical explanation of the demand for money.
Classical Approach
The classical approach to the demand for money is best summed up in the naive
quantity theory of money which states that people hold cash balances or money
only to carry on economic transactions—for making purchases and sales of goods
and services—in the economy. According to the classicists, money did not influence
the real processes of production and distribution in the economy. As the medium
of exchange, money merely facilitated the exchange of goods and services serving
in the process as a labour-saving device in the economy. Behind the ‘veil of money’,
Say’s Law of Markets operated in the same manner as it did in the barter economy.
According to John Stuart Mill, money was intrinsically insignificant, By serving as
the medium of exchange, it had relieved society of the great inconveniences of
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64 Material
According to the classicists, the demand for money primarily depends on Introduction to Money
the level of transactions which was determined by the level of aggregate income.
The level of aggregate income was the full employment income because in the
classical economic analysis there was no obstacle to the attainment of such a level
of income since supply always created its own demand. The classical approach to NOTES
the demand for money has been best summarized by Don Patinkin in the following
words.
‘In its cash balance version...neo-classical theory assumed that, for their
convenience, individuals wish to hold a certain proportion, K, of the real volume
of their planned transactions, T, in the form of real money balances. The demand
for these balances thus equals KT. Correspondingly, the demand for nominal money
balances is KPT, where P is the price level of the commodities transacted. The
equating of this demand to the supply of money, M, then produced the famous
Cambridge equation, M = KPT. In the transactions version—associated primarily
with the names of Newcomb and Fisher—the velocity of circulation, V, replaced
its reciprocal, K, to produce the equally famous equation of exchange, MV = PT.
These equations were the parade grounds on which neo-classical economists then
put the classical quantity theory of money through it paces.’
The classicists considered only the transactions demand for money which
depended on the volume of total money transactions in the economy within the
framework of static equilibrium analysis. However, since under the static
assumptions, the income and payments flows are perfectly synchronized in time in
the economy, no transactional cash balances would be needed. In reality, however,
the income and spending flows do not arise simultaneously—the income flow is
discrete and lumpy occurring in the case of salaried workers once in a month while
the spending flow, being more continuous, occurs almost daily. Similarly, a firm
has to pay for the purchase of raw materials, hiring of labour and other inputs
more frequently while the revenue from the sale of manufactured goods is received
long after the factor payments are made. Thus, the two flows occur at different
points in time. The disparity in time which exists between the income and spending
flows in the economy is necessary for holding money for purposes of transactions.
In other words, as the means of payment, money is demanded as a temporary
abode of purchasing power to bridge the time interval gap between the flows of
money receipts or income and money spending. It is not, however, sufficient to
explain the presence of transactional cash balances. If the institutional structure
permitted the people to convert their idle transactional cash balances into riskless
yield-giving almost perfectly liquid financial assets, (e.g., savings bank deposits in
banks with no restriction on withdrawals), they would convert all their cash balances
into such assets since these could be readily and without suffering any loss converted
into cash when needed for the transactional purpose. Thus, according to the modern
economists, it is the lack of synchronization between the income and spending
flows together with the institutional framework which does not make available
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Introduction to Money perfectly liquid income-yielding financial assets which creates the transactional
demand for money in the economy.
Some later writers, trained in the classical tradition, had recognized that
since under the static assumptions no one would like to hold cash, K would be
NOTES
zero or V would approach infinity. But in practice V was finite. In their opinion, it
was due to the uncertain nature of future transactions needs. This motive for holding
money is termed as the precautionary motive. The basis for this motive for holding
cash is that unforeseen contingencies may arise requiring immediate money
spending and which might lead to further expenses and inconvenience (as in the
case of an accident, sudden illness of oneself or other family members or any
other unforeseen mishap) or the loss of an unexpected excellent opportunity if
sufficient purchasing power was not available ready at hand. Like the transactions
demand for money, the precautionary demand for money was also regarded as a
function of the level of income. The modern approach to the demand for money
explains that the transactions demand for money depends on the ratio of the cost
of converting money into and out of the income-yielding financial assets and the
return which could be enjoyed by owning these assets.
In summary, the classical approach to the demand for money treated it as a
constant function of the level of money income, i.e., M = KY. In the equation, M,
K and Y denote respectively the transactions demand for money, the constant
positive fraction or percentage of Y which the community holds in the form of
money and the money value in terms of the current rupees of national product or
real income.
The asset demand for money arising from money’s function as a permanent
store of value was least stressed by the classicists. According to them, money
was barren or unproductive and wealth stored in the form of money did not multiply.
Unlike the government bonds, bills and debentures money yields no interest income
to its owner; unlike corporate equities it promises no dividends, capital gains or
insurance against inflation; and it offers none of the services for which real assets—
land, house, refrigerator, etc.,—are held. One could always go to the money or
capital market and store wealth in the productive form by purchasing the government
bonds or corporate debentures and shares. By converting one’s surplus money
into the riskless fixed interest-income yielding government bonds one can earn
interest income while storing one’s wealth. For example, a one hundred rupee
bank note remains a one hundred rupee bank note even after one year if it is
stored in the suitcase or safe-vault while a one-year maturity government bond of
the face value of ‘100 bearing 6 per cent interest rate becomes worth ‘106 after
one year. A rational individual wealth-holder would, therefore, always prefer
government bonds, debentures, savings banks deposits or equity shares to money
for storing value—unspent portion of his current earnings. In the classical scheme
of things no one would demand money for asset purposes. This behaviour would,
however, prevail only if the current rate of interest was also expected to prevail in
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future, i.e., if the elasticity of expectations was zero. The neglect of the asset demand Introduction to Money
for money was a serious lacuna in the classical approach to the demand for money.
Keynesian Approach
John Maynard Keynes’ approach to the demand for money is contained in Chapter NOTES
15 of his well-known book titled The General Theory of Employment, Interest
and Money. The classical economists did not stress the permanent store of value
function of money. Consequently, the asset demand for money remained completely
neglected in their analysis. According to Keynes, the classical approach to the
demand for money was faulty because it ignored the possibility of people choosing
to hold money as an asset instead of holding the other financial assets, particularly
government bonds when their prices are expected to fall. Keynes explained that
the fall in the capital value of a government bond consequent upon even a small
increase in the market rate of interest might more than offset the interest income
received on such a bond. If the market price of bonds was expected to fall, (i.e.,
the market rate of interest was expected to rise), a rational wealth-holder would
not always convert money into government bonds even though money was sterile
in the sense that it yielded no return in the form of interest income to its owner. To
account for such a behaviour, Keynes added the speculative or asset demand for
money to the transactions and precautionary demand for money.
According to Keynes, an individual’s aggregate demand for money in the
given circumstances is the result of a single decision which is the composite of the
transactions, precautionary and the speculative motives for holding money.
The transactions motive has been further classified into the income motive and the
business motive. Under the income motive, the aggregate amount of money
demanded depends on ‘the amount of income and the normal length of the interval
between receipt and its disbursement.’ Under the business motive, the aggregate
amount of money demanded chiefly depends on the value of current output, i.e.,
current income and the number of hands through which the current output passes.
The precautionary demand for money, which depends on the precautionary
motive, arises from the need ‘to provide for contingencies requiring sudden
expenditure and for unforeseen opportunities of advantageous purchases.’
The strength of the transactions and precautionary motives for holding money
depends partly on the cheapness and the reliability of various methods of obtaining
cash when required and partly on the relative cost of holding cash. For example, if
people can borrow temporarily through the overdraft facilities provided by the
banking system, there will be no necessity to hold cash balances to bridge the time
interval between the receipt of income and its disbursement on various items of
expenditure. Similarly, if the opportunity cost of holding the cash balances in the
form of interest income forgone is high, the strength of these motives will be weak
and people will not hold large cash balances for satisfying the transactions and
precautionary motives for holding money.
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Introduction to Money According to Keynes, the demand for money to satisfy these motives, ‘is
generally irresponsive to any influence except the actual occurrence of a change in
the general economic activity and the level of incomes; whereas experience indicates
that the aggregate demand for money to satisfy the speculative motive usually
NOTES shows a continuous response to gradual changes in the rate of interest, i.e., there
is a continuous curve relating changes in the demand for money to satisfy the
speculative motive and changes in the rate of interest as given by changes in the
prices of bonds and debts of various maturities.’ In short, Keynes regarded the
transactions and precautionary demand for money as a direct and positive function
of the level of money income and the speculative demand for money as a negative
function of the rate of interest. We may now discuss each one of these three
demands for money in detail.
5.4 MONETARY STANDARDS: GOLD,

BIMETALLISM AND PAPER CURRENCY
SYSTEMS
There are two types of monetary standards—one far more prevalent in developed
economies than other. Monetary standards refer to the ‘system’ or ‘framework’
that controls or facilitates the movement of money. The following are the two
monetary standards:
 Commodity standard
 Inconvertible ‘managed’ paper standard
1. The Commodity Standard
This standard exists where the value of monetary units equal the value of specific
amounts of commodity (e.g., gold).
Examples of commodity standards are as follows:
 Monometallic/metallic coin standards
 Metallic exchange standard
 Bimetallic standard
There are some pros and more cons. There are evidently problems with
these standards since they have been discarded as the monetary standard of choice.
One inherent problem for the bimetallic standard is described in Gresham’s Law.
On one hand, it does restrain the government from excessively expanding
the money supply because MS is driven by physical availability of metal not political
experience. However, metal reserves may expand excessively, or conversely
contract when the economy needs liquidity to grow.
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Pros also include the intrinsic value of silver and gold. Cost of producing Introduction to Money
metals is inversely related to general level of prices (it provides stability to economic
output and prices), however, the process may be too slow.
2. Inconvertible ‘managed’ paper standard NOTES
This monetary standard is created by the government. Another term given to it is
‘fiat’ money. This system only works because the government values the legal
tender and the public accepts the standard. The public has to accept the standard
since the paper itself isn’t actually worth anything—it’s an abstraction. It fails when
the government does not exhibit proper economic restraint and responsibility (i.e.,
massive hyperinflation).
Classification of Money
Gresham’s law is an economic principle ‘which states that when government
compulsorily overvalues one money and undervalues another, the undervalued
money will leave the country or disappear from circulation into hoards, while the
overvalued money will flood into circulation’. It is commonly stated that ‘bad
money drives out good’, but is more accurately stated: ‘Bad money drives out
good if their exchange rate is set by law.’
This law applies specifically when there are two forms of commodity money
in circulation which are required by legal-tender laws to be accepted as having
similar face values for economic transactions. The artificially overvalued money
tends to drive an artificially undervalued money out of circulation and is a
consequence of price control.
Gresham’s law is named after Sir Thomas Gresham (1519–1579), an English
financier during the Tudor dynasty. However, the law had been stated forty years
before by Nicolaus Copernicus, so in Poland it is known as the Copernicus-
Gresham Law. The phenomenon had been noted even earlier, in the 14th century,
by Nicole Oresme. The fact of bad money being used in preference to good
money is also noted by Aristophanes in his play The Frogs, which dates from
around the end of the 5th century BC.
‘Good’ money and ‘bad’ money‘Good’ money and ‘bad’ money
‘Good’ money is money that shows little difference between its nominal
value (the face value of the coin) and its commodity value (the value of the metal of
which it is made, often precious metals, nickel, or copper.)
In the absence of legal-tender laws, metal coin money will freely exchange
at somewhat above bullion market value. This is not a purely theoretical result, but
may instead be observed today in bullion coins such as the South African
Krugerrand, the American Gold Eagle, or even the silver Maria Theresa thaler
(Austria). Coins of this type are of a known purity and are in a convenient form to
handle. People prefer trading in coins rather than in anonymous hunks of precious
metal, so they attribute more value to the coins. The price spread between face
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Introduction to Money value and commodity value is called seignorage. Since some coins do not circulate,
remaining in the possession of coin collectors, this can increase demand for coinage.
On the other hand, ‘bad’ money is money that has a commodity value
considerably lower than its face value and is in circulation along with good money,
NOTES
where both forms are required to be accepted at equal value as legal tender.
In Gresham’s day, bad money included any coin that had been debased.
Debasement was often done by the issuing body, where less than the officially
specified amount of precious metal was contained in an issue of coinage, usually
by alloying it with a base metal. The public could also debase coins, usually by
clipping or scraping off small portions of the precious metal. Other examples of
‘bad’ money include counterfeit coins made from base metal.
In the case of clipped, scraped, or counterfeit coins, the commodity value
was reduced by fraud, as the face value remains at the previous higher level. On
the other hand, with a coinage debased by a government issuer, the commodity
value of the coinage was often reduced quite openly, while the face value of the
debased coins was held at the higher level by legal tender laws.
Examples of Gresham’s Law
Silver coins were widely circulated in Canada (until 1968) and in the United States
(until 1965 for dimes and quarters and 1971 for half-dollars). However, these
countries debased their coins by switching to cheaper metals as the market value
of silver rose above that of the face value. The silver coins disappeared from
circulation as citizens retained them to capture the higher current or perceived
future intrinsic value of the metal content over their face value, using the newer
coins in daily transactions. In the late 1970s, the Hunt Brothers attempted to
corner the worldwide silver market but failed, temporarily driving the price far
above its historic levels and intensifying the extraction of silver coins from circulation.
The same process occurs today with the copper content of coins such as
the pre-1997 Canadian penny, the US one-cent coin, and the pre-decimal UK
copper pennies and halfpence. This also occurred even with coins made of less
expensive metals such as steel in India.
Gresham’s law states that any circulating currency consisting of both ‘good’
and ‘bad’ money (both forms required to be accepted at equal value under legal
tender law) quickly becomes dominated by the ‘bad’ money. This is because
people spending money will hand over the ‘bad’ coins rather than the ‘good’
ones, keeping the ‘good’ ones for themselves. Legal tender laws act as a form of
price control. In such a case, the artificially overvalued money is preferred in
exchange, because people prefer to save rather than exchange the artificially
demoted one (which they actually value higher).
Consider a customer purchasing an item which costs five pence, who
possesses several silver sixpence coins. Some of these coins are more debased,
while others are less so—but legally, they are all mandated to be of equal value.
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The customer would prefer to retain the better coins, and so offers the shopkeeper Introduction to Money
the most debased one. In turn, the shopkeeper must give one penny in change,
and has every reason to give the most debased penny. Thus, the coins that circulate
in the transaction will tend to be of the most debased sort available to the parties.
NOTES
If ‘good’ coins have a face value below that of their metallic content,
individuals may be motivated to melt them down and sell the metal for its higher
intrinsic value, even if such destruction is illegal. As an example, consider the 1965
United States half dollar coins, which contained 40 per cent silver. In previous
years, these coins were 90 per cent silver. With the release of the 1965 half dollar,
which was legally required to be accepted at the same value as the earlier 90 per
cent halves, the older 90 per cent silver coinage quickly disappeared from
circulation, while the newer debased coins remained in use. As the price of bullion
silver continued to rise above the face value of the coins, many of the older half
dollars were melted down. Beginning in 1971, the US government gave up on
including any silver in the half dollars, as even the metal value of the 40 per cent
silver coins began to exceed their face value.
A similar situation occurred in 2007 in the United States with the rising price
of copper and zinc, which led the US government to ban the melting or mass
exportation of one-cent and five-cent coins, respectively.
In addition to being melted down for its bullion value, money that is
considered to be ‘good’ tends to leave an economy through international trade.
International traders are not bound by legal tender laws as citizens of the issuing
country are, so they will offer higher value for good coins than bad ones. The good
coins may leave their country of origin to become part of international trade,
escaping that country’s legal tender laws and leaving the ‘bad’ money behind. This
occurred in Britain during the period of the gold standard.
History of the concept
The law was named after Sir Thomas Gresham, a sixteenth century financial agent
of the English Crown in the city of Antwerp, to explain to Queen Elizabeth I what
was happening to the English shilling. Her father, Henry VIII, had replaced 40 per
cent of the silver in the coin with base metals, to increase the government’s income
without raising taxes. Astute English merchants and even ordinary subjects would
save the good shillings from pure silver and circulate the bad ones; hence, the bad
money would be used whenever possible, and the good coinage would be saved
and disappear from circulation.
Gresham was not the first to state the law which took his name. The
phenomenon had been noted much earlier, in the 14th century, by Nicole Oresme.
In the year that Gresham was born, 1519, it was described by Nicolaus Copernicus
in a treatise called Monetae cudendae ratio: ‘bad (debased) coinage drives good
(un-debased) coinage out of circulation.’ Copernicus was aware of the practice of
exchanging bad coins for good ones and melting down the latter or sending them
abroad, and he seems to have drawn up some notes on this subject while he was Self-Instructional
Material 71
Introduction to Money at Olsztyn in 1519. He made them the basis of a report in German which he
presented to the Prussian Diet held in 1522 at Grudzidz, attending the session with
his friend Tiedemann Giese to represent his chapter. Copernicus’s Monetae
cudendae ratio was an enlarged, Latin version of that report, setting forth a general
NOTES theory of money for the 1528 diet. He also formulated a version of the quantity
theory of money.
According to the economist George Selgin in his paper ‘Gresham’s Law’:
As for Gresham himself, he observed ‘that good and bad coin cannot
circulate together’ in a letter written to Queen Elizabeth on the occasion
of her accession in 1558. The statement was part of Gresham’s
explanation for the ‘unexampled state of badness’ England’s coinage
had been left in following the ‘Great Debasements’ of Henry VIII and
Edward VI, which reduced the metallic value of English silver coins
to a small fraction of what it had been at the time of Henry VII. It was
owing to these debasements, Gresham observed to the Queen, that
‘all your fine gold was conveyed out of this your realm.’
Gresham made his observations of good and bad money while in the service
of Queen Elizabeth, with respect only to the observed poor quality of British
coinage. The earlier monarchs, Henry VIII and Edward VI, had forced the people
to accept debased coinage by means of their legal tender laws. Gresham also
made his comparison of good and bad money where the precious metal in the
money was the same metal, but of different weight. He did not compare silver to
gold, or gold to paper.
5.5 MONEY MARKET
Money market is a very important segment of the Indian financial system. It is the
market for dealing in monetary assets of a short-term nature. Short-term funds up
to one year and for financial assets that are close substitutes for money are dealt in
the money market. Money market instruments have the characteristics of liquidity
(quick conversion into money), minimum transaction cost and no loss in value.
Excess funds are deployed in the money market which, in turn, are availed to meet
temporary shortages of cash and other obligations. Money market provides access
to providers (financial and other institutions and individuals) and users (comprising
institutions and government and individuals) of short-term funds to fulfil their
borrowings and investment requirements at an efficient market clearing price. The
rates struck between borrowers and lenders represent an array of money market
rates. The interbank overnight money rate is referred to as the call rate. There are
also a number of other rates such as yields on treasury bills of varied maturities,
commercial paper rate and rates offered on certificates of deposit. Money market
performs the crucial role of providing an equilibrating mechanism to even out short-
term liquidity and in the process, facilitate the conduct of monetary policy. Short-
term surpluses and deficits are evened out. The money market is the major
mechanism through which the Reserve Bank influences liquidity and the general
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72 Material
level of interest rates. The bank’s interventions to influence liquidity serve as a Introduction to Money
signalling device for other segments of the financial system.

The Indian money market was segmented and highly regulated and lacked
depth till the late 1980s. It was characterized by a limited number of participants,
NOTES
regulation of entry and limited availability of instruments. The instruments were
limited to call (overnight) and short notice (up to 14 days) money, interbank deposits
and loans and commercial bills. Interest rates on market instruments were regulated.
Sustained efforts for developing and deepening the money market were made
only after the initiation of financial sector reforms in the early 1990s.
Check Your Progress

3. Mention the names of the two monetory standards.
4. Where does the commodity standard exist?
5. After whom is Gresham’s law named?

QUESTIONS
1. Money Market system refers to a market for short-term funds.

2. Money market consists of several sectors or sub markets such as ‘call loan
market’, ‘bill market’ or ‘discount market’, ‘acceptance market’, ‘collateral
loan market’, etc.
3. The two monetary standards are commodity standard and inconvertible
‘managed’ paper standard.
4. The commodity standard exists where the value of monetary units equal the
value of specific amounts of commodity (e.g., gold).
5. Gresham’s law is named after Sir Thomas Gresham (1519–1579).
5.7 SUMMARY
 A ‘Money Market’ is a mechanism which makes it possible for borrowers

and lenders to come together.
 A money market is not homogenous in character. It consists of several sectors
or sub markets such as ‘call loan market’, ‘bill market’ or ‘discount market’,
‘acceptance market’, ‘collateral loan market’, etc.
 The major short term credit instruments dealt with in a money market include
trade bills, bankers acceptances, treasury bills, short dated government
securities, commercial papers, certificates of deposits and money market
mutual funds.
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Material 73
Introduction to Money  Call Money Market is the sub market specializing in call loans which are
sometimes referred to as ‘loans at call and short notice’.
 An important source of financing trade and industry is the money market.
Through discounting operations of bills and commercial papers, the money
NOTES
market finances the short-term working capital requirements of trade and
industry and facilitates their development.
 Money market exercises an equilibrating influence on the demand for and
supply of loanable funds.
 The central bank of the country is the leader of the money market. It has a
pivotal role. The entire money market operations will be controlled by making
funds available depending upon the economic cycles.
 The commercial banks can rightly be considered as the nucleus of the whole
money market. As such a developed money market will have a well organized
and properly integrated commercial banking system capable of meeting the
genuine short-term credit needs of the economy.
 In the literature on monetary theory while the analysis of the demand for
money— -motives for holding cash balances—has been the main focus of
economists’ attention, study of the supply of money has received relatively
scant attention.
 In India, the Reserve Bank of India (RBI) has adopted the narrow and
broad concepts of the money supply.
 The classical approach to the demand for money is best summed up in the
naive quantity theory of money which states that people hold cash balances
or money only to carry on economic transactions—for making purchases
and sales of goods and services—in the economy.
 There are two types of monetary standards—one far more prevalent in
developed economies than other. Monetary standards refer to the ‘system’
or ‘framework’ that controls or facilitates the movement of money.
 Gresham’s law is an economic principle ‘which states that when government
compulsorily overvalues one money and undervalues another, the
undervalued money will leave the country or disappear from circulation into
hoards, while the overvalued money will flood into circulation’.
 Gresham’s law is named after Sir Thomas Gresham (1519–1579), an English
financier during the Tudor dynasty.
 Gresham’s law states that any circulating currency consisting of both ‘good’
and ‘bad’ money (both forms required to be accepted at equal value under
legal tender law) quickly becomes dominated by the ‘bad’ money.
 Money market is a very important segment of the Indian financial system. It
is the market for dealing in monetary assets of a short-term nature.
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5.8 KEY WORDS
 Currency: Currency refers to a system of money in general use in a

particular country. NOTES
 Market: A market is defined as the sum total of all the buyers and sellers
in the area or region under consideration.
 Economy: Economy refers to the state of a country or region in terms of
the production and consumption of goods and services and the supply of
money.

EXERCISES
1. Write a short note on money market.
2. What do you understand by bill market and collateral loan market?
3. What is the narrow aprroach towards the supply of money?
4. What is the classical approach to the demand for money?
1. What are the features of a developed market? Discuss.
2. Discuss the different approaches to the supply of money.
3. Write a detailed note on the monetary standards in India.
4. What is Gresham’s law? Give some examples of Gresham’s law.

Delhi.
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Material 75
Foreign Exchange
and Control BLOCK - II
INDIAN BANKING SYSTEMS
NOTES
UNIT 6 FOREIGN EXCHANGE AND
CONTROL
Structure
6.0 Introduction
6.1 Objectives
6.2 Foreign Exchange
6.3 Exchange Market and Rate of Exchange
6.4 Exchange Control
6.6 Summary
6.7 Key Words
6.0 INTRODUCTION
It has been widely recognized that a country should conserve its foreign exchange
resources. It is all the more important in the case of developing economies. Foreign
currency is required for the purpose of importing essential capital goods from
other countries. These countries have to resort to a number of artificial restrictions
in the realm of dealing in foreign currency. At the same time, they have to ensure
that other countries would not retaliate. It is well-known that external monetary
stability is as important as internal stability. In a way both are closely inter-related
in such a manner that the shock recorded in one sector will automatically be
transmitted to the other sector.
6.1 OBJECTIVES

 Understand the meaning of foreign exchanges
 Discuss exchange market and rates of exchange
 Know about exchange control
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76 Material
Foreign Exchange
6.2 FOREIGN EXCHANGE and Control
With the development of international trade and the subsequent international division
of labour, it has become imperative for countries to devote more and more attention NOTES
to the complicated mechanism of ‘foreign exchange’. We may take a very simple
example. Suppose a person in India imports goods worth £10,000 from England.
The exporter in England has to be paid in pound sterling. This simple operation
involves a number of complicated problems. The first one is the method by which
to determine the value of rupees in terms of pound sterling. Then there is the
problem of finding out ways and means to settle this transaction. Under the gold
standard system, gold can be used as a medium of exchange and the transaction
can be settled without difficulty since it is easy to find out the gold contents of a unit
of each currency. But with the suspension of the gold standard system, the problem
became complicated. Besides the problem of finding out a common medium of
exchange and the rate at which one currency can be converted into another,
countries began to face such problems as the artificial restrictions imposed on the
exports and imports and the arbitrary fixation of the rate of exchange. The actions
taken by one country led to similar actions by other countries. The result was a
war on the economic front. Thus, countries found it advisable to have an organization
on the lines of the United Nations established for the purpose of avoiding war. The
result was the establishment of the International Monetary Fund with a view to
assuming international monetary cooperation. The Fund could, to a certain extent,
remedy the disastrous results of fixing arbitrary exchange rates. The problems of
finding out a common medium of exchange and the rate at which one currency can
be converted into another were partially solved. This does not, however, means
that trade between countries flows on smoothly.
The question of mitigating frequent fluctuations in the rate of exchange is
also important. Unless there is a stability in exchange rates, international trade is
rather difficult. For instance, let us take the case of an importer in India who has
imported raw materials worth $10,000 from the US which amount has to be paid
after three months. Suppose the existing rate of exchange is $1 = 48. So, the
importer in India will consider the cost of raw materials as 4,80,000. By the time
he has to pay the amount to the exporter, suppose the exchange rate goes up to,
say, $1 = 50. Here the importer stands to lose. In the opposite case, the exporter
will be the loser. In short, there must be some mechanism to lessen such fluctuations
in the rates of exchange and also to relieve genuine businessmen from the risks of
such fluctuations. A detailed knowledge and study of these and other allied problems
are, therefore, necessary for understanding international trade. Herein lies the
importance of ‘Foreign Exchange’.
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Foreign Exchange The term ‘foreign exchange’ is used to denote either a foreign currency or
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the rate at which one currency is converted into another or the means and methods
by which one currency is exchanged for another. Thus, foreign exchange is
concerned with the settlement of international indebtedness, the methods of effecting
NOTES the settlements and the instruments used in this connection, and the rates of exchange
at which the settlements of international indebtedness are made.
Balance of Trade and Balance of Payments
The term ‘balance of trade’ denotes the relation between the imports and exports
of commodities of a country. Balance of trade refers to only visible items entering
into international trade. In other words, balance of trade takes into account only
the goods imported or exported. These goods are visible in the sense that they are
recorded in the returns of the customs department.
When the difference is an excess of exports over imports, a country is said
to have a ‘favourable balance of trade’ from the point of view of that country.
When the imports are more than exports, it is called an ‘unfavourable balance of
trade’ from the point of view of that country. These terms, viz., favourable balance
of trade and unfavourable balance of trade are often misleading. A favourable
balance of trade need not necessarily indicate the economic prosperity of a country.
There are a number of items other than the export and import of goods which
have to be taken into consideration while settling international indebtedness. For
instance, suppose India is exporting more goods than what she imports. We can
consider India as having a favourable balance of trade. But she may be indebted
to other countries on various other accounts such as cost of transportation,
insurance, services of foreign technicians, interest payments on foreign loans, etc.
The total payment which she has to make on these accounts may far outweigh the
excess of exports over imports, viz., the balance of trade. Thus, a favourable
balance of trade is not always a sign of economic prosperity. In the same manner,
an unfavourable balance of trade need not necessarily mean that the economic
position of the country is weak. In this connection, it may be pointed out that
England had a steadily growing unfavourable balance of trade for many years
while her national wealth had been steadily increasing. Therefore, in order to know
whether a country is economically prosperous or not, all the items entering into
international trade have to be taken into consideration. In other words, it is ‘balance
of payments’ and not ‘balance of trade’ that is important.
‘Balance of payments’ includes not only the visible items of exports and
imports but also the invisible items of exports and imports which make a country
creditor to another and vice versa. Invisible items refer to those items which are
not recorded in the customs returns as they have no tangible form. They take the
form of services rendered by one country to another and include the services of
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foreign shipping, banking and insurance, etc. Balance of payments is ascertained Foreign Exchange
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by taking into consideration the following items:
1. The most important item entering in the balance of payments is the balance
of trade.
NOTES
2. Secondly, invisible items of exports and imports form part of the balance
of payments. Invisible items may be of various kinds like transport
service, shipping freights, passenger fares, harbour and canal dues,
telephone and telegraph fares, commercial services (fees and
commission), financial services (brokers’ fees, etc.,) and services
connected with tourist traffic.
3. Another item entering in balance of payments is interest payment. If a
country has invested money in foreign countries, it will receive interest
payments. Conversely, a debtor country will have to pay interest to
other countries.
4. Items of government transactions such as the salaries of diplomatic
representatives, reparations, gifts, donations, etc., are also reckoned
with while arriving at the balance of payments. They are generally
grouped under the head ‘miscellaneous items’.
Sometimes these items are broadly classified under visible and invisible items.
The former embrace the items entering into balance of trade, and the latter all
other items creating international indebtedness.
There is another classification of balance of payments into Current Account
Balance and Capital Account Balance. The current account balance consists of all
receipts and payments arising out of transactions in goods and services during the
current period. In other words, the current account balance consists of all receipts
and payments which do not create a new capital item or cancel a previously existing
capital item. The capital account balance is composed of receipts and payments
which do not relate to the current period. It may be divided into two parts, viz., the
short-term capital account and the long-term capital account. The former includes
all changes in gold, foreign bank balances and other short-term debits and credits.
The latter is composed of receipts and payments which give rise to long-term
capital claims.
Check Your Progress

1. Why is foreign currency required?
2. What does the term ‘balance of trade’ denote?
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Foreign Exchange
and Control 6.3 EXCHANGE MARKET AND RATE OF
EXCHANGE
NOTES The rate of exchange between two currencies is the amount of one currency that
will be exchanged for one unit of another currency. For instance, if $1 can be
exchanged for 47.25, the rate of exchange between dollars and rupees is $1 =
47.25. When the rate of exchange is quoted as so many rupees per dollar, it is
known as the ‘dollar rate’. On the other hand, when it is quoted as so many
dollars per rupee, it is known as the ‘rupee rate’. In the same way, the sterling rate
between India and the UK is the amount of rupees that will be exchanged for one
unit of pound sterling.
Rate of Exchange under the Gold Standard System
When a country is on the gold standard system, actual gold coins will be in
circulation, or the currency note will be convertible into metallic gold by tendering
it at the central bank. There will not be any artificial restrictions in the movement of
gold into or out of the country.
When two countries are on the gold standard system, determination of the
rate of exchange between their currencies is comparatively easy. It will be in
proportion to the gold contents of one unit of one currency expressed in terms of
the gold contents of one unit of the other currency. Let us assume that India and
the US are on the gold standard. Further that one rupee contains one unit of gold
of 11/12 fineness and one dollar contains 47.25 units of gold of the same fineness.
Then the rate of exchange between the US dollar and rupee will be $1 = 47.25.
This rate is known as the equilibrium rate of exchange or the ‘mint par of exchange’.
The mint par of exchange has been defined as ‘the number of units of the one
currency which should legally contain the same amount of pure metal as does,
legally, a given number of units of the other currency’.
Limits to the Fluctuations in the Rate of Exchange under
the Gold Standard System
The fluctuations in the rate of exchange under the gold standard system are limited.
Even if the market rate of exchange is temporarily different from the mint par of
exchange, it will always have a tendency to come back to the equilibrium level,
viz., the mint par. Let us examine how the forces operate to make the market rate
equal to the mint par.
Suppose, ‘A’ in India is importing goods worth $1,000 from the US. ‘A’
can settle this transaction either by sending 47,250 units of gold (assuming that the
mint par is $1 = 47.25) or by purchasing $1,000 from an exchange dealer. The
exchange dealer will be in possession of foreign exchange sold to him by exporters.
Let us further assume that the exchange dealer quotes an exchange rate of
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$1 = 48. In other words, ‘A’ has to spend 48,000 to purchase $1,000. In that Foreign Exchange
and Control
case, he will prefer to send 47,250 units of gold to the US, where the exporter in
that country can change it for $1,000. This is because ‘A’ can purchase 47,250
units of gold with 47,250 whereas if he purchases $1,000 he will have to spend
48,000. This will have the effect of decreasing the demand for dollars in India, NOTES
forcing the exchange dealers to bring down the market rate of exchange for dollars.
This process will go on till the market rate becomes equal to the mint par.
This, however, is subject to one modification. Sending gold involves certain
expenses like packing charges, shipping charges, loss of interest while gold is in
transit, insurance charges, refining charges, etc. To continue the above example, if
‘A’ wants to send gold worth $1,000, he will have to buy 47,250 units of gold by
spending 47,250. Then he will have to get it packed and send it by sea or air,
thereby incurring freight charges. Further, he should see that the gold is refined so
as to bring it on a par with the fineness of gold obtainable with the American
monetary authorities. This involves refining charges. Again, during the course of
transit, gold is locked up in an idle manner. Assuming that it takes one month for
transportation of gold from India to the US, ‘A’ will be losing interest for 47,250
during that period. Furthermore, ‘A’ has to incur insurance charges in connection
with the insurance of gold transported. Let us suppose, these expenses amount to
250. This means that to send gold worth $1,000, ‘A’ has to incur 47,500 in all.
Thus, although the mint par of exchange is $1 = 47.25, the rate as far as ‘A’ is
concerned works out to 47.50 when he uses gold as the medium of exchange. If
the market rate of exchange is above this point, ‘A’ will prefer to send gold. This
will be the case with other importers also. The resulting decrease in the demand
for dollars will force the exchange dealers to bring down the market rate of exchange
to $1 = 47.50. This point is known as the ‘Gold Export Point’ or the ‘Upper
Specie Point’ from the point of view of India and the ‘Gold Import Point’ or the
‘Lower Specie Point’ from the point of view of the US. Likewise, there is a ‘Gold
Import Point’ for India and a ‘Gold Export Point’ for the US. These points are
known as the ‘Gold Points’ or the ‘Specie Points’. To sum up, the equilibrium rate
of exchange (or, the mint par of exchange) under the gold standard system is likely
to fluctuate but these fluctuations are strictly limited to the gold export point and
the gold import point, otherwise known as the specie points.
Rate of Exchange under the Inconvertible Paper Currency System
The Purchasing Power Parity Theory

Determination of the rate of exchange under the gold standard system has now
only a theoretical importance. Today no country is following the gold standard
system. The system being followed now is the inconvertible paper currency system.
Under this system, the currency authorities do not undertake any obligation to
convert currency notes into gold. In other words, the notes are inconvertible. The
determination of the rate of exchange under such a system is complicated.
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Foreign Exchange During the inter-war period, Prof. Gustav Cassel, a Swedish economist,
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advanced a theory known as the ‘Purchasing Power Parity Theory’, explaining
the determination of the rate of exchange under the inconvertible paper currency
system. According to him, the rate of exchange will depend on the price levels in
NOTES the respective countries. To take a simple example, if the price of a commodity in
India is 4,725 in India and if the same commodity is priced in the US at $100, the
rate of exchange between US dollar and rupee will be $1 = 47.25. Cassel wrote:
‘Our willingness to pay a certain price for foreign money must ultimately
and essentially be due to the fact that this money posses a purchasing power as
against commodities and services in that foreign country. On the other hand, when
we offer so-and-so much of ones own money, we are actually offering a purchasing
power as against commodities and services in our own country. Our valuation of
a foreign currency, therefore, depends mainly on the relative purchasing power of
the two currencies in their respective countries’. Again, the rate of exchange between
two currencies must stand essentially on the quotient of the internal purchasing
power of these currencies. Evelyn Thomas explains the theory thus:
‘…while the value of the unit of one currency is determined at any particular
time by the market conditions of demand and supply, in the long run that value is
determined by the relative values of the two currencies as indicated by their relative
purchasing power over goods and services’. In other words, the rate of exchange
tends to rest at that point which expresses equality between the purchasing power
of the two currencies. This point is called the ‘purchasing power parity’.
So long as the price levels in the two countries remain the same, the rate of
exchange will also remain the same. A concrete example will make the point more
clear. Suppose one dollar purchases 47 units of rice in the US and one rupee
purchases one unit of rice of the same quality in India. Then the equilibrium rate of
exchange is $1 = 47. Let us assume that the market rate of exchange moves to
the level of $1 = 94. The demand for Indian rice in the US will immediately go
up. This is because an American can convert one dollar into 94 and with this
amount he can purchase 94 units of rice in India whereas in his own country he
can get only 47 units of rice. Conversely, the demand for American rice in India
will decrease. The combined effect of these two forces will be to push up the
value of rupees. Suppose the rate of exchange moves up in India’s favour to $1 =
80. Even then it will be cheaper for Americans to purchase Indian rice. The
demand for rupees will continue to remain high. This process will go on till the rate
of exchange becomes equal to $1 = 47. At this point, Americans will have no
preference for Indian rice. The rate of exchange can not move below this point.
This is because in such a case Indians will prefer to purchase rice from America
and the demand for dollars will increase. This will tend to bring back the rate of
exchange back to the equilibrium level. Thus, so long as the price levels remain the
same, the rate of exchange has always a tendency to remain at the equilibrium rate
of exchange, otherwise known as the ‘purchasing power parity’. If the price levels
change, the equilibrium rate will also record corresponding changes.
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Although the theory is stated in such simple terms, we have to take into Foreign Exchange
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consideration the cost of transporting goods from one country to another as also
the duties and other restrictions imposed by the importing country. The equilibrium
rate of exchange will no doubt be influenced by these factors.
NOTES
Criticisms
Purchasing Power Parity Theory is one of the most widely criticized theories. In
the first place, it is said that the term ‘price level’ is a very vague one. The general
price level of a country includes the prices of both nationally traded and
internationally traded commodities. At the same time, it is important to note that all
prices do not enter into the calculations of those who carry on foreign trade. This
introduces a complication into the theory. Are we to take into consideration the
price levels of only internationally traded commodities? If we accept this as the
basis of price levels, there is a further difficulty. It is not easy to divide commodities
under the two strict heads of nationally traded and internationally traded. This is
because changes are constantly taking place in the assortment of commodities
entering national trade and international trade. For instance, rise in the price of a
foreign currency will make hitherto nationally traded commodities exportable. So
also, certain imported articles hitherto will move out of the list of internationally
traded commodities.
Further, as Lord Keynes has remarked, when the price level is confined to
the prices of internationally traded commodities, the Purchasing Power Parity Theory
breaks down to an empty truism. This is because the national prices of internationally
traded commodities follow the movements in exchange rates rather than determine
them. In order to overcome this difficulty, if we take into consideration the general
price level of both nationally traded and internationally traded commodities another
difficulty will arise. The only method to measure price levels in two countries is to
ascertain the index numbers. For this purpose, the index number of wholesale
price levels is more suitable. The result obtainable by comparing the index numbers
is acceptable only if they are representative of costs and prices of things that move
in international trade. But when we compare the index numbers of wholesale price
levels, it is doubtful whether the prices of goods entering into international trade
will move in the same direction as indicated by the index numbers. Of course, in
the long run they will move in the same direction. Thus, the theory holds good only
in the long run. During the short-term period, the actual exchange rate may be
different from the equilibrium rate. In other words, the theory attempts to explain
the ultimate rather than the immediate forces determining the rate of exchange.
Another criticism against the theory is that it does not take into consideration
the fact that fluctuations in prices are not the only factor influencing the exchange
rate. It is also influenced by changes in the economic relations between two countries
even when the price levels remain the same. For instance, when a new competitor
as a purchaser or seller emerges in the world market, the trade between two
countries will be affected. As observed by Ragnar Nurkse, ‘the Purchasing Power
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Foreign Exchange Parity Theory treats demand simply as a function of price, leaving out of account
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the wide shifts in aggregate income and expenditure which occur in the business
cycle (as a result of market forces or government policies) and which lead to wide
fluctuations in the volume and hence the value of foreign trade even if prices or
NOTES price-relationship remains the same. It is possible for a country to maintain its
exchange rate well above the purchasing power parity for a number of years if it
resorts to borrowing from foreign countries’.
Further, as Cassel himself has admitted, even in the long-term period changes
in transportation costs, customs duties, terms of trade etc., will influence the rate
of exchange. The equilibrium rate of exchange as determined with the help of
Purchasing Power Parity Theory may not be on a par with the existing market rate
of exchange. For example, if the transportations costs suddenly increase, the
exchange value of the currency will be affected even though the price levels remain
the same. In the words of Cassel, ‘differences in the two countries’ economic
situation particularly in regard to transport and customs may cause the normal
exchange rate to deviate from the quotient of the currencies’ intrinsic purchasing
powers’.
In the same way, sales and purchases of foreign securities, banking
transactions, etc., affect demand and supply of currencies. We do not consider
these factors while constructing index numbers.
Another objection is raised against the view of Cassel is that while changes
in price levels bring about changes in exchange rates, changes in exchange rates
have no influence over price levels. This view is not correct. Changes in exchange
rates can and do influence the price levels. Let us take a concrete example. Suppose
the exchange rate between US dollars and rupees is $1 = 47. This means a
commodity worth 470 in India will cost $10 in the US. As a result of certain
capital movements suppose the value of dollars decreases so as to bring the
exchange rate to the level of $1 = 30. The commodity worth 470 in India will
now cost $15.66 in the US. At the same time imports from the US will become
cheaper. The demand for American goods will increase in the world market. It will
have the effect of raising their prices in the US. Simultaneously, India will reduce
her prices so as to encourage exports. Thus, price levels in the US increase and
price levels in India decrease. In other words, a change in the exchange rate
influences the price levels. This has actually happened in the case of the UK
subsequent to the fall of the pound sterling in 1931.
To sum up, Purchasing Power Parity Theory has a number of limitations.
Nevertheless, the theory can not be rejected as such. It gives us at least a rough
idea as to where the exchange rate should be located in the long run. During
periods of unstable and fluctuating exchange rates, Purchasing Power Parity Theory
provides a rough estimate of the extent to which the market rate of exchange
deviates from the equilibrium rate.
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Balance of Payments Theory Foreign Exchange
and Control
The Balance of Payments Theory is an extension of the theory of value to the field
of foreign exchange. In easy and simple terms, the theory states that the rate of
exchange is fixed at the point where the demand for foreign currency is equal to its NOTES
supply. The various items of imports give rise to the demand for foreign currency
and the various items of exports give rise to its supply. Thus, the rate of exchange
is that rate which equates imports and exports.
The balance of payments theory thus states that the rate of exchange is
determined by the balance of payments in the sense of supply and demand. The
theory places emphasis upon changes in the terms of trade between countries and
international capital movements as the leading forces governing exchanges rates
and internal prices. Superficially viewed, the principle involved is correct. But
differences will arise when we endeavour to analyse the forces governing the supply
of and demand for foreign currency. In terms of the explanation given by the
advocates of the theory, the supply of and demand for foreign currency (balance
of payments) are determined mainly by factors that are independent of variations
in the rate of exchange. They contend that there are certain independent factors
which are fixed such as interest on foreign loans, reparation payments, etc. Further,
they hold that the demand for many of the items entering in the import trade is
perfectly inelastic so that variations in the rate of exchange will not have any influence
on them. In support of their argument, they point out the example of certain raw
materials which have to be purchased from particular countries whatever the price
may be.
The merit of this theory lies in the fact that it is in line with the demand and
supply theory of value. Besides, it correctly states that exports and imports of
visible items alone are not the only consideration influencing the rate of exchange.
Balance of payments includes both visible and invisible items. Obviously, the invisible
items have a bearing on the rate of exchange. Further, the theory explains that the
disequilibrium in the balance of payments can be corrected by an adjustment in the
exchange rate.
The most important criticism raised against the theory is that it considers
balance of payments to be a fixed quantity. We have seen earlier that balance of
payments is not generally a fixed quantity. Balance of trade is one of the most
important items entering into balance of payments. The balance of trade depends
on the price levels existing at home and abroad and it fluctuates according to the
fluctuations in price levels. Lord Keynes has criticized the theory by comparing
balance of trade to a sticky mass and suggesting that it applies to the theory of
solids where that of liquids would be more appropriate.
The contention of the advocates of the theory that the demand for many
imported raw materials is inelastic is also criticized. There is practically no
commodity, the demand for which is perfectly inelastic. Even in the case of internal
trade, the demand for any commodity can not be considered as perfectly inelastic,
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Foreign Exchange let alone the question of inelasticity of demand in the field of international trade.
and Control
Changes in the rate of exchange do cause variations in the balance of payments.
Thus, balance of payments which is influenced by the rate of exchange can not be
considered as the only factor determining the rate of exchange.
NOTES
Factors Causing Fluctuations in Exchange Rates
The theories discussed above indicate only the determination of the long-term
exchange rates. The market rate of exchange existing on any particular day need
not be the same. The causes giving rise to such fluctuations may be grouped as
follows:
Short- term Factors:
1. Commercial
2. Financial
Long-term Factors:
1. Currency and Credit Conditions
2. Political and Industrial Conditions
The short-term factors, viz., commercial and financial factors, directly
influences the supply of and demand for foreign currency. They may further be sub
divided into trade factors, stock exchange factors and banking factors.
Trade factors relate to the influence arising from the exports and imports.
Suppose, the equilibrium rate of exchange between India and the US is $1 = 47.
For some reasons, the exports from the US increase more than the imports. That
means India will have to give more dollars to the US. The demand for dollars
increases. Obviously the market rate of exchange will move away from the
equilibrium rate in favour of the US. Conversely, if the imports to the US are more
than her exports, the rate of exchange will fluctuate in India’s favour.
Stock exchange factors relate to the influences arising from the granting of
loans, repayment of loans, receipt of interest payments, purchases and sales of
foreign securities, etc. For example, suppose America is granting a loan to India.
The demand for rupees will increase in America. The result is fluctuation of the
rate of exchange in India’s favour. Conversely when the loan is repaid the rate will
fluctuate in America’s favour. In the same way, payment of interest, sales and
purchases of foreign securities, etc., will cause fluctuations in the equilibrium rate
of exchange.
Banking factors relate to the influences arising from the operations of banks
such as purchases or sales of bankers’ drafts, traveller’s letters of credit, arbitrage
operations, changes in bank rate, etc. For instance, the sale of a draft on a foreign
centre creates demand for foreign currency and raises its value. The exchange
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rate will move in favour of the foreign currency concerned. Again, a high bank rate Foreign Exchange
and Control
will make investments lucrative in the home country. Foreigners will try to transfer
their funds to that country. This will raise the demand for the currency of the country
concerned and the rate of exchange will move in favour of that country.
NOTES
Currency and credit conditions of a country also influence the rate of
exchange. Exchange dealers are always careful to watch the probable trend of the
internal and external value of a country’s currency. If the total quantity of note
issue is steadily rising without a corresponding increase in the total volume of
goods, the result will be inflation. The increased prices of the commodities will
cause a decrease in its exports. An adverse balance of payments position will
develop. Such a state of affairs is likely to induce exchange dealers to dispose off
their stock of home currency as early as possible. This will increase the supply of
home currency relative to its demand, thus causing a fluctuation in the rate of
exchange unfavourable to the home currency. In the same way, the budgetary
policies of a country will also cause fluctuations in the rate of exchange. Where it
appears that the extent of public expenditure is incompatible with the national
prosperity of the country, exchange dealers will try to dispose off their stock of
that currency. This results in the fluctuation of the rate of exchange unfavourable to
the country concerned. Conversely, if public expenditure is justified by the national
income, exchange dealers will anticipate a movement of the rate of exchange in
that country’s favour. They will then try to stock more of that currency. The resulting
increase in demand will cause a movement in the rate of exchange in that country’s
favour.
The political conditions and the internal industrial situation of a country also
cause fluctuations in the rate of exchange. As observed by Evitt:
‘A stable government, the strict maintenance of law and order, the protection
of property and of the rights of owners of wealth will all induce an inflow of foreign
capital, either for interest gaining purposes or for safety; political unrest, attempts
to overthrow the government either by force or by constitutional methods, the
growth of and possible accession to power of a body of political thought inimical
to capital, will all include the withdrawal of capital and prevent any further influx of
funds from abroad’. Again, ‘settled and amicable conditions between capital and
labour, a stable level of wages commensurate with selling prices on the level of
world prices, evidence of enterprise and efficiency on the part of those responsible
for the direction of industry, will all operate as long-term factors in causing an
appreciation of the international exchange value of the currency’. In short, stable
political and industrial conditions will cause fluctuations in the rate of exchange in
favour of the country concerned. Conversely, unstable political and industrial
conditions will cause fluctuations in the rate of exchange against the country
concerned.
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Foreign Exchange Problem of Stabilization of Exchanges: Fluctuating Rates
and Control
(Free Exchanges) vis-à-vis Stable Rates (Fixed Exchanges)
NOTES The question as to whether the exchange rates should be kept stable or whether
they should be allowed to fluctuate freely is a disputed one. A categorical answer
in favour of any of these propositions can not be given because it will be
advantageous for a country to keep the rate stable at some time and allow it to
fluctuate freely at some other time. The following paragraphs examine the arguments
raised for and against each of these.
The most important argument raised in favour of freely fluctuating rate is
that if the rate of exchange is kept rigidly fixed, the inflationary and deflationary
conditions developing in other countries will automatically be transmitted to such a
country. The validity of this argument is, however, dependent on the question as to
whether the foreign trade of the country concerned is considerable or not. In the
case of a country where foreign trade plays a large part, this argument holds good.
For instance, let us assume that India is importing a large volume of goods from
the US. Suppose, a commodity entering into the trade between India and the US
is priced at $100 in the US. Taking the rate of exchange as $1 = 57, its price will
be 5,700 in India, subject to freight and other expenses. Now, if inflationary
conditions develop in the US, these will be reflected in India also. For example, if
the price of this commodity increase to $200 in the US, its price in India will also
be doubled (assuming stable or fixed rate of exchange is maintained). Conversely,
a fall in the prices of commodities or depression in the US will cause similar economic
conditions in India also. In short, fixed rates of exchange are liable to transmit
inflationary and deflationary conditions from abroad.
It should be remembered in this connection that freely fluctuating exchange
rates are also inimical to the balanced and stable growth of the economy. Frequent
fluctuations in the rate of exchange are likely to cause violent fluctuations in the
prices of many commodities. Such fluctuations in the prices may displace certain
commodities from the international trade. The country will be compelled to reallocate
its resources between the export and home-market industries. Such reallocation
is often disturbing and wasteful.
Another argument raised in favour of fluctuating rates is that such fluctuation
will enable the countries to prevent a balance of payment crisis, thus facilitating
international trade. This argument is also not as weighty as it apparently appears
to be. On the other hand, freely fluctuating exchange rates often lead to a breakdown
in international trade since traders will not be willing to undertake the risks of
unanticipated fluctuations in exchange rates. Of course, it is true that a part of such
risks can be eliminated through the device of forward exchange. However, in one
sense this is also a serious disadvantage of free rates. Unscrupulous speculators
will start dealings in foreign exchange markets in order to make profits from such
fluctuations. The very dealings of a speculative nature of such transactions are
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liable to cause serious fluctuations in exchange rates without any rational justification Foreign Exchange
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behind it. As observed by Ragner Nurkse in International Currency Experience:
‘Anticipatory purchases of foreign exchange tend to produce or at any rate
hasten the anticipated fall in the exchange value of the national currency, and the
NOTES
actual fall will set up or strengthen expectations of a further fall. The dangers of
such cumulative and self-aggravating movements under a regime of freely fluctuating
exchanges are clearly demonstrated by the French experience of 1922–26’.
Moreover, because of the chances of making windfall profits, businessmen
will try to maintain a high state of liquidity. Only then they will be able to take
advantage of sudden fluctuations in the rates of exchange. Obviously this discourages
investment, thus affecting adversely production and employment.
Thus many of the arguments raised by the advocates of freely fluctuating
exchanges rates have lost much of their significance. It is rather unwise for any
country to leave its exchange rate to fluctuate according to the demand and supply
formula and allow the equilibrating influence of the balance of payments work
freely and automatically. No doubt, it is true that in the case of a country with a
large volume of foreign trade, stable rates are liable to attract the inflationary and
deflationary conditions developing in other countries.
In conclusion, we may say that while exchange rate variations are certainly
an unsuitable and undesirable means of dealing with short-term discrepancies in
the balance of payments, an absolute rigidity of rates of exchange in the face of
drastic changes in other factors at home and abroad may thus be equally harmful.
The overall interest may call for an occasional readjustment of the value of currencies
in order to eliminate, as far as possible, any chronic and structural disparity between
price levels and rates of exchange in different countries. The realization of this
objective has led to the establishment of the International Monetary Fund, the
details of which are elaborated in the next chapter.
Check Your Progress

3. What do you understand by the rate of exchanges between two currencies?
4. What does the balance of payments theory state?
6.4 EXCHANGE CONTROL
‘Exchange control’, in the simplest sense, denotes the methods by which a country
controls the demand for and supply of foreign exchange. Haberler defines exchange
control as ‘the state regulation excluding the free play of economic forces from the
foreign exchange market’. With the abandonment of the gold standard system and
the disappearance of the ‘automatic’ controls of exchange, countries found it
necessary to adopt some methods of control over the internal and external value
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Foreign Exchange of their currencies. Such controls date back to the First World War period.
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However, the world-wide depression of the late 1920s which culminated in the
financial collapse of the 1930s gave birth to new techniques of exchange control.
During the Second World War period, the severity of the exchange control methods
NOTES followed by various countries led to a complete breakdown of international
economic relations. Complete domination over the foreign exchange market was
the order of the day. Payments and receipts of foreign currency on any account
were subjected to strict government control. The post-war period witnessed a
relaxation of these controls. But the return of the pre-war independence of the
exchange market was out of question. Moreover, countries emerging from the
war-torn economies found it absolutely necessary to continue some form of control
in the realm of foreign exchange.
AIMS of Exchange Control
The primary objective of exchange control in the case of vast majority of countries
is to stimulate exports and discourage imports. The exchange value of the country’s
currency will be artificially kept down. This reduces the price levels of home products
in the world market. At the same time, prices of imported commodities increase.
Thus, imports are discouraged and exports are encouraged. For example, suppose
the price of a commodity is 2,000 in India when the rate of exchange between
India and the US and India was $1 = 50. In terms of US dollars, the price of that
commodity is $40. In case the exchange value is brought down to $1 = 100, the
same commodity will cost $20 although the internal price remains at 2,000. At
the same time, price of a commodity priced in the US at $40 will go up to 4,000
as far as India is concerned. Hence, from the point of view of the American people
the price of Indian commodity decreases and from the point of view of Indians the
price of American commodity increases. The depreciation of the Japanese yen
provides an early example of this type of exchange control, which was later adopted
by many other countries.
Another object of exchange control is to prevent capital exports. Citizens
of the country will be prohibited from entering into any contract leading to export
of capital. Foreigners are also prohibited from withdrawing their assets.
A third object of exchange control is to provide short run exchange stability.
Under the inconvertible paper currency system, the automatic free interplay of
demand and supply formula does not operate. This makes exchange rates very
unstable. Short run stability of the exchanges is particularly important from the
point of view of promoting international trade. As such, countries adopt various
methods of controlling the exchange rates temporarily. The Exchange Equalization
Funds provide a suitable example.
Exchange control is also adopted to maintain stable relations with some
other foreign currency. This is all the more important when a country has important
trade relations with such a country. For example, rupee had a strong link with
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pound sterling. The devaluation of pound sterling during the late 1940s was followed Foreign Exchange
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by the devaluation of rupee.
A further objective of exchange control is to conserve a country’s foreign
exchange resources so that they may be used for the purpose of meeting international
NOTES
obligations. Closely connected with this is the objective of ensuring the available
supply of foreign exchange resources to repay the principal and interest to the
creditor countries. During the 1930s, many debtor countries resorted to exchange
control because they could not float new loans to repay their outstanding debts.
The export proceeds were subject to strict government control.
During times of war exchange controls are designed to restrict the use of
purchasing power of enemy nations, their subjects and agents. The control measures
adopted by various countries during the Second World War provide an example.
A state of national emergency such as a major war demands the complete
mobilization and state control over national resources of all kinds. As observed by
Evitt, ‘In addition to imposing measures which give the state complete control
over all the external resources of the country, further measures to control the volume
and direction of both export and import trade will be introduced, so as to conserve
national resources by preventing unessential expenditure abroad and to ensure
that only goods surplus to the national war effort are exported, and then only (as
far as possible) to countries from which essential purchases must be made and for
which the export proceeds can be used in payment’.
Crowther describes three possible objects of exchange control. These are:
1. Undervaluation (Devaluation)
2. Overvaluation
3. Maintenance of the exchange rate at stable level equivalent to the
equilibrium level (Avoidance of Fluctuations)
Undervaluation
Undervaluation or devaluation denotes the lowering of the external value of
currency. It means depreciation in the external value of the currency of the devaluing
country and appreciation to the extent of devaluation in the external value of the
currency or currencies of the country or countries in whose relationship the country
has devalued her currency. Such a step would promote exports and discourage
imports. This is because, as observed earlier, the internal prices will be relatively
advantageous as compared to prices prevailing in the world market. Undervaluation
is generally resorted to when there is an over-production of goods and a sort of
depression in the market. It will help in lifting the economy from the depressed
state by stimulating exports.
However, it should not be assumed that a policy of undervaluation will always
have the desired effects. Sometimes the external prices will fall. This danger is
particularly important in the case of countries enjoying a good share of the
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Foreign Exchange international trade. Also, since prices are affected through exports and imports,
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the desired objective of modifying the price levels is more likely to be achieved
when foreign trade is extensive than when it forms only a small proportion of the
aggregate trade of the country. It is important to note in this connection that
NOTES devaluation will be successful only if the foreign country or countries in relation to
which a country devalues its currency accepts such a policy. The foreign country
or countries can effectively defeat the objects of devaluation by adopting counter
measures such as raising tariff rates or granting subsidies to the producers so that
their prices are also lowered. For example, suppose India devalues her currency
from $1 = 50 to $1 = 100. A commodity which was priced at $10 ( 500) will
now cost only $5 ( 500, since the new rate of exchange is $1 = 100). This
decrease in the price level is supposed to stimulate exports. Suppose the US
raises the tariff rate on this commodity by $5. For all practical purposes, the price
remains at $10. The foreign country or countries may also resort to depreciation
of its/their currencies. Thus, the effects of depreciation of one currency will be
neutralized by the depreciation of the other currency/currencies. The great
depression provides us with numerous examples of competitive exchange
depreciation. As observed by Crowther: ‘undervaluation is a game that any one
can play but if everyone plays at it and currencies enter upon a competition to see
which can be pushed far those below its real value, it quickly develops into a race
to render all currencies worthless’.
Overvaluation
Overvaluation denotes the fixing of the value of a currency at a higher level than it
would be if there was no intervention to the foreign exchange market. Such a step
is generally adopted when there is a serious imbalance in a country’s balance of
payments. The ultimate result would be a fall in the exchange value of a currency.
At the same time the country may be in need of foreign goods essential either for
war time needs or for economic development of the country. If, under these
circumstances, the exchange rate is allowed to fall the cost of imported goods will
become very high. The only possible course is to keep up artificially the value of
the currency. For instance, during the Second World War period, the British
Government maintained the value of pound sterling at a higher level than its actual
position because of the necessity to purchase essential raw materials from abroad.
Secondly, a country suffering from inflation will have to overvalue its currency.
If some sort of control is not resorted to, the value of the currency will decline
sharply. This is especially important when foreign trade plays a significant role in a
country’s economy. Unless the downward course of the exchange value is arrested,
inflationary tendencies will become more serious. Under such conditions, a country
will overvalue its currency.
Thirdly, overvaluation is necessary for countries which have to make large
payments of money expressed in terms of foreign currencies. Such countries are
under the necessity of acquiring large amounts of foreign currency. The cost of
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their debt repayment will at least appear to be less if the value of their currencies is Foreign Exchange
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kept at a high level relatively to those of the foreign currencies. For example,
suppose India has to make a payment of $10 million to the US and the debt was
contracted when the rate of exchange was $1 = 60. The total amount of the debt
in terms of our currency is 600 million. If rupee is overvalued at $1 = 50, the NOTES
debt will at least appear to be 500 million.
However, there is another side of the picture of overvaluation. It will have
the effect of raising the internal price levels relatively to the price levels prevailing in
the world market. Thus, the exports of the country resorting to overvaluation will
be crippled. History has shown us the adverse effects of overvaluation to a country’s
economy. Great Britain between 1925 and 1931, France between 1932 and 1936
and other countries at other times have learnt that overvaluation is a most violent
malady, the more puzzling as the effects seem to be far larger than the cause. It is
one of the surest ways of producing a general economic depression. To quote
Crowther again, ‘a sort of progressive paralysis appears to creep over the whole
economy of a country whose currency is overvalued’.
Although overvaluation appears as affecting exports adversely by causing
an upward trend in the export prices when expressed in terms of a foreign currency,
such a course may be desirable and necessary under certain circumstances. It
may not be possible to lay down any rigid formula as to when a country should
overvalue its currency or undervalue its currency. We may agree with Crowther
when he says that in times of war and scarcity overvalue your currency. In times of
slump and surfeit undervalue your currency.
Avoidance of Fluctuations
The third object of exchange control is avoidance of temporary exchange
fluctuations. Though admirable in theory, this object is difficult to be achieved in
practice. It is not easy to identify temporary fluctuations. Exchange Equalization
Funds provide an example of the attempt to iron out temporary ups and downs in
exchange value. The history of the British Exchange Equalization Fund contains
instances of occasions which necessitated both overvaluation and undervaluation.
Devaluation of the Rupee
In 1949, the rupee was devalued. The decision came in the wake of the devaluation
of the pound sterling. In September 1949, Britain announced its decision to devalue
pound sterling by reducing the sterling-dollar exchange rate from £1 = $4.03 to
£1 = $4.80. In September itself, the Government of India announced its decision
to devalue rupee by the same extent. As a result, the rupee-sterling rate remained
the same as before, viz., 1 = 1s 6p, while the rupee-dollar rate was changed to
1 = 21 cents (instead of 1 = 30.225 cents).
Of course, there was no legal obligation for India to maintain its link with
pound sterling. Nevertheless, in view of the fact that most of our trade connections
were with the sterling area countries, we had no alternative. Incidentally, it may be
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Foreign Exchange remarked that 28 currencies followed the devaluation of pound sterling. The large
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volume of trade of India with most of these countries actually compelled India to
devalue her currency as well. The decision was taken ‘not on conviction born of
logic necessarily but, so to speak, by the compulsion of events’ Taking 1948–49,
NOTES the volume of our trade with the sterling area countries was around 592 crore as
compared to 262 crore with the hard currency area. If the rupee had maintained
its value in spite of the devaluation of so many currencies, Indian goods would
have become more costly with the result of a decrease in demand in the usual
markets. Devaluation, thus, became a defensive necessity.
Effects of Devaluation
1. The rupee equivalent of our borrowings from the IMF and the World Bank
increased overnight from 47.64– 68.57 crore.
2. The cost of imports from dollar area suddenly increased by nearly 30–50
per cent. Of course, cost of imports from sterling area countries (which had
devalued their currencies) remained the same.
3. Prices of Indian goods in the dollar area markets decreased by nearly 30
per cent. This was an advantage since this had the effect of stimulating our
exports to those markets.
4. The index number of wholesale prices and the cost of living index did not
show any appreciable increase. This indicates that the internal price levels
and trade equilibrium were not adversely affected by devaluation. Although
by June 1950, the index numbers began to rise. This rise was not entirely
due to devaluation.The outbreak of the Korean War played a significant
role in this price increase.
5. The immediate effect of devaluation on India’s balance of trade was
favourable.
Nevertheless, the advantages of devaluation in India were short lived as
compared to the advantages derived by other countries from the devaluation of
their currencies. In the case of India, the export surplus was limited while most of
the other countries could make full use of their productive capacity they had, thus
increasing the export surplus for dollar market area. The productive capacity of
India, on the other hand, was limited and was further handicapped by the increased
prices of essential imports of capital goods and raw materials from foreign markets,
especially the dollar area countries.
Proposals for Revaluation of the Rupee
The inflationary conditions that had prevailed in the economy since 1950 led to a
controversy regarding the desirability of revaluing the rupee. It was contended by
the advocates of revaluation that the fixing of a higher exchange rate for the rupee
would check inflation and would result in considerable saving in the country’s
import costs. Late Dr John Mathai was an ardent advocate of revaluation.
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According to him, the recognized internal remedies for inflation were by themselves Foreign Exchange
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not likely to be immediately operative in India. He pointed out that in spite of the
government’s strenuous efforts, no substantial economies in public expenditure
were within sight. According to him, ‘Taxation has already been pushed to the
point of diminishing returns. Savings on a voluntary basis are difficult to come by NOTES
and schemes of compulsory saving will encounter serious administrative
difficulties… Credit control which in other countries is frequently put forward as a
means of combating inflation has little application in India… . The development
schemes now in progress are not expected to reach the stage of production for
some years to come while scarcity of materials and lack of capital for replacement
and expansion are hampering existing industries. Price control, besides being
increasingly difficult to administer, is in reality no remedy for inflation but only
serves to spare some of its obvious symptoms’.
The opponents of revaluation pointed out that revaluation of rupee would
seriously affect our exports to sterling area countries because such a step would
make our goods costly. Indian exports would find it difficult to compete in the
international market. The government was opposed to a policy of revaluing the
currency. In 1951, the then Union Minister of Finance stated that a revaluation of
the rupee would not be in the interest of the country. According to him, ‘the
conclusion that the Reserve Bank experts have arrived at is that a 15 per cent
revaluation would probably involve a balance of payment deficit of round about
50 crore and a 30 per cent revaluation would involve a deficit in the balance of
payments of 135 crore whereas, if we do not revalue we shall probably hold
things square’. The question of revaluing the rupee was thus rejected.
Second Devaluation of the Rupee
Since independence, rupee was devalued for a second time in June 1966. The par
value of the rupee was changed from 18.66 grams of gold per 100 rupees to
11.85 grams of gold. In other words, this involved a reduction in the external value
of rupee by 36.5 per cent. The immediate provocation for the devaluation of the
rupee for a second time was the suggestion made by the IMF and the World Bank
to the Government of India to devalue the rupee. It was true that prices in India
had been continuously rising since the beginning of the First Five Year Plan. During
the decade 1956–1966, the general price level rose by about 80 per cent. This
made the internal value and the external value incompatible since the official rate of
exchange was remaining the same all through this period. Devaluation of the rupee
thus became an immediate necessity. The problem assumed significance especially
in view of the fact that the unofficial rate of exchange prevailing was much different
from the official rate.
Moreover, as admitted by the then Union Minister of Finance, the rise in
prices in India had no comparison to the rise in prices in other countries with which
India traded. As a result, our exports had been meeting with increasing competition.
In addition, it was pointed out that devaluation would reduce leakages in foreign
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Foreign Exchange exchange earning caused through anti-social practices such as under-invoicing of
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exports, over-invoicing of imports, remittances through unofficial channels,
smuggling, etc.
NOTES De-linking of the Rupee with Pound Sterling

In September 1975, India decided to delink rupee with pound sterling. Following
the snapping of rupee’s link with pound sterling, a series of revaluations started as
far as rupee was concerned. The first one was in December 1975. As a sequel to
the delinking of the rupee from the pound sterling, the Indian strategy had been to
prevent the rupee from sliding down with pound sterling on a long-term basis. A
part of the strategy had been to permit an effective devaluation of the rupee for
short spells in terms of the US dollar, Japanese yen, etc., in order to give a boost
to exports.
Linkage of the Rupee with a Basket of Currencies
At present, the rupee is linked with a small number of chosen currencies known as
‘basket of currencies’. The currencies selected for inclusion is the basket are the
currencies of those countries which are our major trading partners. The object is
obviously to give a degree of stability to the rupee. Since all the currencies included
in the basket are not likely to fluctuate in one direction all at the same time, it is
expected that violent fluctuations in the rate of exchange are unlikely. Of course
the day-to-day rate may vary within a small margin which will be announced from
time to time. Thus, what we follow today is neither a rigidly fixed rate nor a freely
fluctuating rate; but a floating rate within certain limits.
Methods of Exchange Control
The methods of exchange control may be broadly grouped under two heads, viz.,
intervention and restrictions. Intervention denotes the activities of the government
in entering the exchange market either to purchase or sell foreign exchange in
order to bring the rate of exchange up or down to the desired level. Restrictions
denote the activities of the government in preventing the existing demand for or
supply of the currency in which they are interested from reaching the exchange
market.
Intervention
This is a direct method of intervening in the exchange market. The government will
be ready to purchase any amount of home currency that can not be taken by the
market and to sell foreign currencies in exchange for that. Thus the existing demand
for and supply of foreign exchange are artificially controlled by the authorities. For
example, the internal value of currency depreciates owing to inflation. The
government wants to maintain its external value at a higher level than that warranted
by the purchasing power parity in order to facilitate international transactions. This
can be done by increasing the supply of foreign currencies in the exchange market.
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Large scale purchase of the home currency in the exchange market in exchange Foreign Exchange
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for foreign currencies will also have the effect of reducing the supply of home
currency. Conversely, a country which wants to fix the exchange value of the
currency at a lower level may do so by increasing the supply of home currency in
the exchange market. These acts of fixing the exchange value of a currency to a NOTES
particular rate are known as pegging operation. Pegging operation generally means
pegging up. The term pegging down is used to signify the maintenance of the
exchange value of the home currency at a lower level. Obviously the ability of a
government to carry on pegging operations depends on the volume of foreign
exchange at its disposal. Of course, in the case of pegging down, its success
depends on the ability of the authorities to increase the supply of home currency
through taxation, public borrowing or creation of additional legal tender currency.
As observed by Crowther: ‘a government that is pegging its currency must be in a
position to pay out foreign currencies and receive its own currency. A government
that is ‘pegging down’ its currency must be in a position to pay out its own currency
and receive foreign currencies and both must be prepared to go on indefinitely
unless they want either to resort to restrictions or to fail in their purpose of controlling
the rate of exchange’. It is true that pegging down is easier than pegging because
it is easier for a country to produce more of its currency in times of emergencies
which is not so easy in the case of foreign currencies. However, it should not be
forgotten that the adoption of such a short cut will bring in its wake all the evils of
inflation. As a matter of fact, inflation would assist the pegging down operation
because any rise in prices would tend to lower the equilibrium value of the currency.
If the operations are continued indefinitely, it will result in disastrous inflation. Hence,
it should be adopted only as a temporary expedient. Both pegging up and pegging
down should be adopted only as temporary measures, and even then with caution.
The maintenance of the exchange value of pound sterling during the First
World War period is a good instance of pegging up. The exchange value of pound
sterling began to depreciate under the adverse balance of payments position. To
counter this, the British Government undertook pegging operations. It raised loans
in the US and with these funds, the supply of dollars was maintained at a fixed
rate. France and Italy had also adopted the same procedure to peg their currencies
to pound sterling.
Exchange Equalization Fund
Intervention is also used for the purpose of ironing out temporary fluctuations in
the exchange value of a currency. Exchange Equalization Funds are the outcome
of such a policy. An Exchange Equalization Fund (or, Exchange Equalization
Account) may be defined as a collection of assets segregated under a central
control for the purpose of intervention in the exchange market to prevent undesirable
fluctuations in the rates of exchange. With the help of this fund foreign currency is
purchased or sold at fixed rate of exchange, maintaining the exchange value of the
home currency more or less fixed. This, of course, involves the overvaluation of
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Foreign Exchange the currency in question at sometimes and undervaluation at others. The British
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Exchange Equalization Fund provides a typical example.
The British Exchange Equalization Fund was set up in April 1932, immediately
after the suspension of the gold standard system by England. It was the depreciation
NOTES
of sterling in terms of gold currencies that prompted the British Government to
establish such a fund. The seriousness of the depreciation of pound sterling can be
gauged from the fact that the exchange value of sterling in terms of US dollar
steadily declined from £1 = $4.86 2/3 to £1 = $ 3.23 on 8 December 1934. The
importance of London as an international financial centre which caused speculative
movements of funds in and out of the country was the main factor which imparted
a degree of instability to pound sterling.
The main object of the British Exchange Equalization Fund is to prevent
undue fluctuations in the rates of exchange. The objective of the Fund is not to aim
at maintaining pound sterling at a fixed parity with gold or the dollar or any other
currency, but is to be operated, in the first instance, for the purpose of counteracting
temporary fluctuations in the exchange transactions and capital movements and
allow sterling to depreciate or appreciate only in accordance with the major
movements in the net balance of payments.
The initial capital of the fund was £ 25 million in US dollars together with an
undisclosed amount of gold which the treasury had purchased from time to time in
the open market since the abandonment of the gold standard system. These assets
were supplemented by an authority for the Fund to raise an amount of £ 150
million by borrowing, which amount has since been raised from time to time.
Besides, the entire gold holdings of the Bank of England are now under the
management of the Fund.
The mode of operation of the Fund is as follows:
When there is a flight of capital to London, the Fund readily purchases it
with the help of pound sterling at its disposal. This helps to avoid an over-supply
of the foreign currency concerned causing fluctuations in the rate of exchange. At
the same time, the Fund accumulates large amounts of foreign exchange. When
there is a flight of capital from London, the Fund readily supplies the necessary
foreign exchange in exchange for pound sterling. This is done with the help of
previously accumulated foreign exchange. Such an action equilibrates demand
and supply. Moreover, the Fund acts as a shock absorber in neutralizing the effects
of capital transfers on the internal credit structure.
Following the example of England, various other countries established such
Funds. Though the activities of these Funds did not reach the same level as those
of the British Exchange Equalization Fund, the main objectives and mode of
operation are the same. A study of these funds shows that their main objectives
are to iron out temporary fluctuations in the rate of exchange and to safeguard
against the disturbing influence arising from the flight of capital and gold into and
out of the country.
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Restrictions Foreign Exchange
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Exchange restrictions are exchange control proper. The term ‘exchange restrictions’
refers to the policy of the state in preventing the existing demand for and supply of
foreign exchange from reaching the exchange market. Austria and Germany were NOTES
the pioneers in the field of exchange restrictions. The financial crisis of 1931
witnessed the emergence of many forms of exchange restrictions. The types and
methods of these restrictions were different in different countries and in the same
country at different periods. Following are given certain types of restrictions usually
met with:
1. Unofficial discouragement of capital export and speculation.
2. Official prohibition of capital export and speculation applied by the banks.
3. Prohibition of capital export and speculation applied by the authorities.
4. Application of the prohibition of export on foreign capital—transfer moratoria
and legal authorization to defer payment.
5. Allocation of foreign exchange for importers by permits.
6. Compulsory surrender of existing foreign exchange holdings by private
interests.
7. Compulsory suspension of free dealings.
Multiple Exchange Rates
Under this method, different exchange rates are fixed for exports and imports of
different goods. The object is to earn as much foreign exchange as possible by
encouraging exports and discouraging imports. For instance, different varieties of
German marks used to be sold in London at different rates. Many countries followed
this practice during the immediate post-war period.
Clearing Agreements
Under a clearing agreement between two countries, importers in both countries
pay into an account in their respective central banks the purchase price of all
commodities imported. The proceeds are then used to meet the export obligations.
The agreement generally fixes the rate of exchange. When export credits and
import debits do not offset each other, exporters are paid only when funds are
available on the clearing agreement. The objects of such an agreement are to
regulate imports according to the wishes of the government, to ensure equilibrium
in the balance of payments and to prevent uncertainties of fluctuating exchanges.
Clearing agreements are criticized on the ground that they are bilateral agreements
standing in the way of the development of international trade. Another criticism is
that such an agreement is likely to enable an economically stronger nation to exploit
an economically weaker nation. In order to obtain payments for its exports under
a clearing agreement, the weaker country may be compelled to import unwanted
commodities.
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Foreign Exchange Payments Agreements
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Payments agreements are slightly better than clearing agreements. Under the former,
mutual credit facilities are allowed so that the exporter will be paid by his central
NOTES bank as soon as information is received that the importer has honoured his
obligation. This avoids delay in payment and the consequent difficulties of the
exporter.
Standstill Agreements
Under these agreements, the short-term debts are either converted into long-term
debts or arrangements are made for their gradual payment. In effect, a moratorium
is given on capital movements.
Transfer Moratoria
Under this restriction, people who owe money to foreigners pay the amounts to a
specified authority in local currency. The foreigners will be paid only after the
lifting of the moratorium. Sometimes foreigners are allowed to use these amounts
in the home country in certain specified ways.
Blocked Accounts
This is a combination of standstill agreements and transfer moratoria. The accounts
are blocked in the sense that the foreigners will not be allowed to draw on them.
The main objects of blocking the accounts are the removal of the immediate threat
to the rate of exchange arising from attempts to transfer such funds out of the
country and the reduction of interest charges on foreign debts.
In addition to the above, certain indirect methods of exchange control are
applied by countries. They include the fixation of import tariff, import quotas,
changes in interest rates, etc.
Spot and Forward Exchange
Generally currencies are exchanged on the spot. The rate of exchange quoted for
the purchase or sale of immediate foreign exchange is known as the ‘Spot Rate’.
In contrast to this there is the forward exchange and the ‘Forward Rate’. Forward
exchange denotes foreign exchange to be delivered after a certain period of time.
The rate of exchange for selling such future transactions is known as the ‘Forward
Rate’. Sometimes it will be necessary for business people to sell or purchase
forward exchange. An example will make the point clear. Suppose a businessman
in India is importing certain raw materials from the US on a D/A bill for three
months, priced at US $100,000. Assuming the current rate of exchange is $1 =
50, his cost of the raw materials is reckoned as 50,00,000. Suppose at the end
of the three months, when the payment of the bill is due, the rate of exchange
moves against rupee to $1 = 60. The total cost for the importer on account of the
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raw materials will go up to 60,00,000, thereby incurring a loss of 10,00,000. Foreign Exchange
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This risk can be avoided by purchasing three months forward dollars. This operation
is similar to a hedging operation. The rate quoted by the exchange dealer for the
forward exchange will be based on the spot rate. The forward rate is at a premium,
when less amount of foreign currency is given for one unit of domestic currency. NOTES
The forward rate is at a discount, when more amount of foreign currency is given
for one unit of domestic currency. The following factors are taken into consideration
while quoting the forward rate:
1. Rate of interest at home and abroad– If the rate of interest is higher at
the foreign centre, it is more profitable for the exchange dealer to transfer
funds abroad. Hence the forward rate will be quoted at a discount.
Conversely, if the rate of interest is higher in the home country, forward
exchange will be quoted at a premium.
2. Possibilities to offset one transaction by an opposite one– Some people
want to sell forward exchange and others may require to purchase the same.
The exchange dealer comes in as an intermediary by purchasing from the
former and selling to the latter. This is technically termed as ‘marrying a
contract’. The forward rate will be quoted at a discount if the exchange
dealer has already purchased forward exchange.
3. Currency conditions– If the foreign currency is expected to depreciate,
the exchange dealer will be unwilling to purchase it forward and hence it will
be quoted at a premium.
Though forward exchanges are liable to wide fluctuations during periods of
unstable exchange, it relieves the trader, especially the small traders, of the risk of
fluctuations. The ‘rate of exchange hedging’ relieves the manufacturer of the risks
of fluctuations in the prices of raw materials which he imports from foreign countries.
Check Your Progress

5. What do you understand by exchange of control?
6. What is the primary objective of exchange control?
7. Define overvaluation.

QUESTIONS
1. Foreign currency is required for the purpose of importing essential capital

goods from other countries.
2. The term ‘balance of trade’ denotes the relation between the imports and
exports of commodities of a country.
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Material 101
Foreign Exchange 3. The rate of exchange between two currencies is the amount of one currency
and Control
that will be exchanged for one unit of another currency.
4. The balance of payments theory thus states that the rate of exchange is
determined by the balance of payments in the sense of supply and demand.
NOTES
5. Exchange control denotes the methods by which a country controls the
demand for and supply of foreign exchange.
6. The primary objective of exchange control in the case of vast majority of
countries is to stimulate exports and discourage imports.
7. Overvaluation denotes the fixing of the value of a currency at a higher level
than it would be if there was no intervention to the foreign exchange market.
6.6 SUMMARY
 With the development of international trade and the subsequent international

division of labour, it has become imperative for countries to devote more
and more attention to the complicated mechanism of ‘foreign exchange’.
 It has been widely recognized that a country should conserve its foreign
exchange resources.
 The term ‘foreign exchange’ is used to denote either a foreign currency or
the rate at which one currency is converted into another or the means and
methods by which one currency is exchanged for another.
 The term ‘balance of trade’ denotes the relation between the imports and
exports of commodities of a country.
 ‘Balance of payments’ includes not only the visible items of exports and
imports but also the invisible items of exports and imports which make a
country creditor to another and vice versa.
 The rate of exchange between two currencies is the amount of one currency
that will be exchanged for one unit of another currency.
 When a country is on the gold standard system, actual gold coins will be in
circulation, or the currency note will be convertible into metallic gold by
tendering it at the central bank.
 Determination of the rate of exchange under the gold standard system has
now only a theoretical importance.
 Purchasing Power Parity Theory is one of the most widely criticized theories.
In the first place, it is said that the term ‘price level’ is a very vague one.
 The Balance of Payments Theory is an extension of the theory of value to
the field of foreign exchange.
 The short-term factors, viz., commercial and financial factors, directly
influences the supply of and demand for foreign currency.
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102 Material
 Stock exchange factors relate to the influences arising from the granting of Foreign Exchange
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loans, repayment of loans, receipt of interest payments, purchases and sales
of foreign securities, etc.
 ‘Exchange control’, in the simplest sense, denotes the methods by which a
NOTES
country controls the demand for and supply of foreign exchange.
 The primary objective of exchange control in the case of vast majority of
countries is to stimulate exports and discourage imports.
 Undervaluation or devaluation denotes the lowering of the external value of
currency.
 Overvaluation denotes the fixing of the value of a currency at a higher level
than it would be if there was no intervention to the foreign exchange market.
6.7 KEY WORDS
 Trade: Trade is the activity of buying, selling, or exchanging goods or

services between people, firms, or countries.
 Exchange: An exchange is a marketplace in which securities, commodities,
derivatives and other financial instruments are traded.
 Devaluation: Devaluation is a deliberate downward adjustment of the value
of a country’s currency relative to another currency, group of currencies or
standard.

EXERCISES
1. What is the difference between balance of trades and balance of payments?
2. Write as short note on rate of exchange under the gold standard system.
3. How is the rate of exchange determined under the inconvertible paper
currency system?
4. What are the three possible objects of exchange control?
5. What are the effects of devaluation of money?
1. Discuss the meaning and significance of foreign exchange.
2. What is the Purchasing Power Parity Theory? Mention major criticisms to
this theory.
3. What are the main factors causing fluctuations in exchange rates? Discuss.
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Material 103
Foreign Exchange 4. Define exchange control. What are the major aims of exchange control?
and Control
5. What are the major proposals for revaluation of money? Discuss.
NOTES 6.9 FURTHER READINGS

Delhi.
Self-Instructional
104 Material
Banking Regulation
UNIT 7 BANKING REGULATION Act, 1949
ACT, 1949
NOTES
Structure
7.0 Introduction
7.1 Objectives
7.2 History, Social Control and Applicability
7.4 Summary
7.5 Key Words
7.0 INTRODUCTION
The enactment of the Banking Regulation Act in 1949 has been a milestone in the
history of Indian joint stock banking. The present unit is an attempt to highlight
certain important provisions in the said Act, which are intended to foster a sound
and healthy banking system in India and the various other measures taken by the
authorities in the recent past to reform and regulate the banking system.
7.1 OBJECTIVES
 Discuss the Banking Regulation Act, 1949
 Understand the history of Banking Regulation Act, 1949
 Explain about the social applicability of the Banking Regulation Act
7.2 HISTORY, SOCIAL CONTROL AND

APPLICABILITY
Let us analyse the history of Banking Regulation Act, 1949 and discuss its important
provisions.
1. Section 6 of the Act lays down specifically the forms of business in which
banking companies may engage. The forms of business specified are in
consonance with accepted banking principles. This section prohibits banking
companies from taking part in trading and speculative activities, thereby
landing themselves in danger. The importance of this section lies in the fact
that one of the main causes that led to the failure of Indian joint stocks
Self-Instructional
Material 105
Banking Regulation during the early part of their development was the varied nature of the
Act, 1949
transactions which many of them undertook and which could never be
characterized as banking transactions. The danger was clearly demonstrated
in the case of the failure of the Indian Specie Bank in 1914. The bank lost
NOTES about 111 lakh on silver speculation alone. The loss in budla deals amounted
to 14 lakh; and loss on advances against pearls amounted to 36 lakh.
2. Section 7 of the Act, as amended in 1963, prohibits the use of any of the
words ‘bank’, ‘banking’ or ‘banking company’ to a company other than a
banking company, or firms, individuals or group of individuals.
3. The Act lays down certain important provisions regarding the minimum paid-
up capital and reserves. According to the original provision (Section 11), it
was possible for a bank with only one place of business to be started with
as low a capital as 50,000. In terms of the Amendment Act of 1962, the
limit of minimum paid-up capital in the case of an Indian banking company
commencing banking business for the first time after the commencement of
the Banking Companies (Amendment) Act, 1962 is fixed at 5 lakh,
irrespective of whether it has only one place of business or places of business
in only one state. Further, if a bank has places of business in more than one
state, and if any such place is situated either in Mumbai or Kolkatta or
both, the minimum amount of paid-up capital is 10 lakh.
It may be noted in this connection that according to the guidelines issued by
the Reserve Bank of India in January 1993, the minimum paid-up capital
for the new private sector banks shall be 100 crore. Similarly, according
to the announcement made by the bank in August 1996, the minimum paid-
up capital of a local area bank shall be 5 crore. The reader’s attention is
invited to the relevant topics discussed in detail later in this chapter.
4. Section 17 of the Act, as amended in 1962, requires every banking company
to transfer to its reserve fund a sum equivalent to not less than 20 per cent of
its profits irrespective of whether or not its reserves have equalled the paid-
up capital. This provision is intended to act as a brake on the policy of declaring
large dividends to satisfy the shareholders, thus undermining sound banking
principles. The Amendment Act was necessitated as a result of the fact that
the paid-up capital and reserves of banks have not kept pace with the increase
in deposits brought about by the growing economic activity during the past
few years. It may be noted in this connection that with effect from the year
ending 31 March 2001, all scheduled commercial banks operating in India
(including exchange banks) are required to transfer not less than 25 per cent
of the net profit (before appropriations) to the reserve fund. This transfer may
be made after adjustment/provision towards bonus to staff.
5. Certain unscrupulous banks used to mislead the ignorant public by showing
large figures of authorized capital as against very fractional amount of paid-
up capital. Also, by calling only a small portion of the subscribed capital,
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106 Material
a very large number of shares than they could actually afford to. For instance, Banking Regulation
Act, 1949
the Poona Bank which went into liquidation in 1924 had an authorized
capital of 10 crore as against a subscribed capital of 50 lakh and a paid-
up capital of 3 lakh. To remove these malpractices, Section 12 (1) of the
Act lays down that the subscribed capital of a banking company must not NOTES
be less than one half of the authorized capital and the paid-up capital must
not be less than one half of the authorized capital.
6. The maximum voting rights of any one shareholder is fixed by the Act, as
amended in 1994, at 10 per cent of the total voting rights. This controls the
concentration of power in any banking company in the hands of a few
shareholders.
7. Interlocking directorates which pave the way for mismanagement are
prohibited under the Act. According to Section 16 of the Act, no banking
company incorporated in India shall have as director any person who is a
director of another banking company.
8. To protect the interests of depositors and to impose restrictions on
indiscriminate loans and advances to directors and concerns in which the
bank or the directors are interested, the Act prohibits a banking company
from making loans or advances on the security of its own shares; or granting
unsecured loans or advances to any of its directors or to firms or private
concerns in which the bank or any of its directors is interested as partner or
managing agent. The nature of loans and advances made by certain banks
before the imposition of this restriction was really unsatisfactory. The failure
of People’s Bank of Lahore indicates the malpractices done by the directors
and such other persons at the helm of affairs. When the bank ceased
operations it was found that 86 lakh out of its total deposits of about 1
crore were advanced to enterprises in which the managing director was
directly and personally interested.
Further restrictions have been imposed in terms of the Banking Laws
(Miscellaneous Provisions) Act, 1963, which are discussed in detail
subsequently in this chapter.
9. Section 24 of the Act as amended in 1962 requires every banking company
to maintain in gold, cash or unencumbered securities, valued at a price not
exceeding the current market price, an amount of not less than 25 per cent
of its total time and demand liabilities. This provision is intended to ensure
the liquidity of the assets of the banks. This section is especially important
since one of the main reasons which led to a number of bank failures in the
past had been the negligence on the part of banks to maintain the liquidity of
their assets in their greed to earn more profits.
10. To safeguard the interests of the depositors, the Amendment Act, 1958
provides for the simplification and speedy disposal of winding up proceedings
of banks.
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Material 107
Banking Regulation 11. The Act provides for the public examination of directors and auditors of
Act, 1949
any bank under liquidation, who are found guilty in the promotion, formation
or proper conduct of business of the bank. Special provisions for assessing
damages against delinquent directors, etc are also laid down in the Act.
NOTES
Banking Companies and the Reserve Bank of India
In addition to the above provisions, the Banking Regulation Act confers certain
powers on the Reserve Bank of India to control the banking companies.
1. Section 21 of the Act confers powers on the Reserve Bank of India to
determine the policy in relation to advances to be followed by banking
companies. Subsection (2) of that section empowers the Reserve Bank to
issue directions to banking companies as to the purposes for which advances
may or may not be made, the margins to be maintained in respect of secured
advances and the rates of interest to be charged on advances. This section
has been amended in 1963 so as to extend the powers of the Reserve
Bank to give directions to banking companies regarding the maximum amount
of advances that may be granted to or the maximum amount up to which
guarantees may be given on behalf of any one company, firm, association of
persons or individual.
2. Section 22 of the Act requires every banking company to obtain a licence
from the Reserve Bank for carrying on or commencing banking business in
India. This is mainly intended to check the growth of unsound banks and to
arrest the indiscriminate floatation of mushroom banks. The Reserve Bank,
before granting a licence to any bank established before the commencement
of the Act in 1949, inspects the whole affairs of the institution concerned
and satisfies itself that the institution is in a position to pay its depositors in
full and that its affairs are not conducted to the detriment of the depositors.
The Reserve Bank is also empowered to cancel a licence already granted.
3. The failure of banks during the past has been attributed, among other reasons,
to the defective management of the banks by persons untrained in banking
techniques and ignorant of sound banking principles. In this connection, it
would of interest to note the failure of the Credit Bank of India. In the
course of the trial, the manager pleaded ignorance of banking or accountancy.
He was ignorant of the meaning of a bill of exchange. The Chairman of the
Board of Directors confessed: ‘Before I became acquainted with the bank,
I had absolutely no knowledge of finance or banking nor I have any now.’
To remedy this defect, the Act of 1949, as amended in 1965, gives power
to the Reserve Bank to regulate the appointment and remuneration of the
senior officers of banks. Further, the Amendment Act of 1956 has
empowered the Reserve Bank to remove from office the Chairman or Chief
Executive Officer of a banking company, if such a person has been found
by any tribunal or any authority to have contravened the provisions of any
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108 Material
law. The Banking Laws (Miscellaneous Provisions) Act, 1963 provides for Banking Regulation
Act, 1949
such removal even when a person has not been found to have contravened
any law; but when he is considered by the Reserve Bank to be acting in a
manner detrimental to the interests of the banking company or to the interests
of the depositors, and covers not only the directors or the chief executive NOTES
but also any other officer or employee.
4. The Reserve Bank is empowered to inspect any banking company at any
time to ensure itself about the efficient performance of the responsibilities of
the banking company concerned. This is particularly useful to promote sound
banking methods among the banking companies. It can call a meeting of the
directors of a bank or change its management when disclosures arising out
of inspection make such a step desirable.
5. The Reserve Bank is authorized to caution any individual bank or banks
generally against a particular transaction or a class of transactions or to
offer advice.
6. The Reserve Bank may, if it thinks necessary, apply to the High Court for
the winding up of any banking company.
7. According to Section 36 of the Act, the Reserve Bank is required to make
an annual report to the Central Government on the trend and progress of
banking in the country, including its suggestions, if any, for the strengthening
of the banking business throughout the country.
8. The provision relating to amalgamation of banks is an important one. The
Act requires any scheme of amalgamation of banks to be approved by the
Reserve Bank. The Reserve Bank, although encourages amalgamation
among sound banking units, does not sanction any scheme of amalgamation
unless it is satisfied that the relevant amalgamation is in the interest of the
depositors, and the amalgamated unit will be able to play a useful role in the
strengthening of the banking structure in the area of operation of the
amalgamating units.
The Reserve Bank is vested with more powers through the recent banking
legislations which are discussed in the following paragraphs.
The Banking Companies (Amendment) Act, 1960
The Banking Companies (Amendment) Act, 1960 inserts a new Section 34 A in
the Banking Regulation Act to make it clear that information, which according to
law is not required to be published in the balance sheet or profit and loss account
of a banking company, need not be disclosed to the authorities set up under the
Industrial Disputes Act. However, the relevant authorities have been empowered
to call for a certificate from the Reserve Bank regarding the amount of such reserves
which may be taken into account for the purpose of the proceedings under the
Act.
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Material 109
Banking Regulation This amendment is intended to protect the secrecy of the inner reserves of
Act, 1949
banks, which is important from the point of maintenance of the confidence of the
depositors, while providing for an independent assessment of the magnitude of
such reserves by the Reserve Bank.
NOTES
The Banking Companies (Second Amendment) Act, 1960
The Banking Companies (Second Amendment) Act, 1960 invests the Reserve
Bank and the government with additional powers aimed at rehabilitation of banks’
difficulties.
The rehabilitation of a bank in difficulties would require a reasonable period
of investigation and negotiation into its position. In order to ensure that during such
a period the bank’s position is not adversely affected, it is advisable to grant the
bank a temporary moratorium. The amended Act provides that the Central
Government may, on an application from the Reserve Bank, make an order up to
a period of six months granting moratorium to a banking company. It is further
provided that during the period of moratorium, the Reserve Bank may prepare a
scheme for reconstruction of the banking company, if this is considered necessary,
and submit it to the Central Government, who may sanction the scheme with
necessary modification. The scheme as sanctioned shall come into force on such
date as shall be specified by the Central Government and shall be binding on the
banking company and also on all the members and creditors thereof.
The Banking Companies (Amendment) Act, 1961
Subsequent to the failure of two scheduled banks in 1960, the Reserve Bank had
taken powers to formulate and carry out, with the sanction of the government,
schemes for the reconstruction and compulsory amalgamation of sub standard
banks with well managed institutions. The bank faced certain operational difficulties
in implementing this programme. As promptness in dealing with the vulnerable
banking institution is as important as the action proposed, the amended Act confers
power on the Reserve Bank to prepare a scheme for the compulsory amalgamation
of any banking company with the State Bank of India or its subsidiaries. It also
permits the amalgamation of more than two banking companies under a single
scheme. Any amalgamation proposed under this scheme is binding not only on the
concerned banking companies, their members and creditors, as applicable hitherto,
but also on their employees and other persons possessing any right or liability in
relation to such banking companies. The Act authorizes the Central Government
to sanction such a scheme with or without modification and to bring it into force on
the date specified by the government. Provision was also made in the amendment
to absorb the entire working staff on existing terms and conditions of service for a
period not exceeding three years. The transfer of assets and liabilities from the
transferor to the transferee bank is facilitated by the provision that by virtue of the
scheme and to the extent provided therein, the properties and assets of the transferor
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110 Material
bank shall vest in the transferee bank and the liabilities of the transferor bank shall Banking Regulation
Act, 1949
be taken over by the transferee bank.
Banking Companies (Amendment) Act, 1962
The Reserve Bank of India (Amendment) Act, 1962 and the Banking Companies NOTES
(Amendment) Act, 1962 have come into force in September 1962. The
amendments were necessitated mainly by two considerations, viz., to strengthen
the banking system and to enable scheduled banks to provide larger credit to
exporters for a longer period.
Several provisions in the original Banking Companies Act, 1949 such as
those relating to capital funds and liquidity ratio of banks were of minimal character
prescribed in the then prevailing context of raising the standard of performance of
many sub-standard banks which had come into existence during the war years.
Since then the conditions have altered and it was considered necessary to strengthen
the financial position of commercial banks. Similarly, in the light of the emphasis on
export promotion and the situation in world markets where other exporting countries
offer medium and long-term credit facilities to the buyers abroad, it was felt necessary
to recognize the paramount need for providing larger credit at reasonable rates to
Indian exporters. This apart, it was found that even existing lending facilities
afforded by the Reserve Bank were not made use of by banks in view of procedural
difficulties. It was, therefore, considered necessary to amend the Reserve Bank of
India Act to simplify the procedures.
The salient features of the amendments to both the banking Regulation Act
and the Reserve Bank of India Act are summarized below.
(a) Statutory Cash Balances
Section 42 of the Reserve Bank of India Act, which stipulates cash reserves of
scheduled banks to be kept with the Reserve Bank, has been simplified to require
scheduled banks to maintain with the Reserve Bank an average daily balance of 3
per cent of their total time and demand liabilities. The cash reserve may now be
varied between 3 per cent and 15 per cent. While fixing the ratio at 3 per cent of
the aggregate of time and demand liabilities, changes in the pattern of deposits of
scheduled banks in the last few years, viz., the large increase in time liabilities as
well as the fall in the usance period of fixed deposits—were also borne in mind. To
bring the non-scheduled banks in line with the scheduled banks, except in regard
to variation of cash reserves, Section 18 of the Banking Regulation Act was
amended so as to require non-scheduled banks to maintain with themselves or in
current account with the Reserve Bank or its agencies, cash balance to the extent
of 3 per cent of their total time and demand liabilities in India as against 5 per cent
of demand and 2 per cent of time liabilities prior to the amendment. Both the
scheduled and non-scheduled banks are required to comply with the respective
provisions from the date of commencement of the concerned Acts.
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Material 111
Banking Regulation (b) Liquidity Ratio
Act, 1949
The liquidity ratio of scheduled banks showed a sizeable decline from around 43
per cent in 1950 to around 33 per cent in 1961. The credit-deposit ratio of banks,
NOTES on the other hand, moved up from 49 per cent to about 70 per cent during the
same period. With prospects of a further rapid rise in bank credit to finance the
expanding requirements of trade and industry and the resulting pressure on the
liquidity of banks in the coming years, it was considered necessary to safeguard
the soundness of the banking system by ensuring that certain desirable minimum
standards of liquidity were adhered to by banks. The amendment to Section 24 of
the Banking Regulation Act provides that the liquid assets required to be maintained
should be 25 per cent of the total demand and time liabilities instead of 20 per
cent, and banking companies were required to comply with the above stipulation
after the expiry of two years from the commencement of the banking Companies
(Amendment) Act, 1962. When the requirement of the amendment came into
force, the practice of computing the liquidity ratio of banks after taking into account
the deposits required to be kept with the Reserve Bank under Section 42 of the
Reserve Bank of India Act (in the case of scheduled banks) and cash balances
required to be maintained under Section 18 of the Banking Regulation Act (in the
case of non-scheduled banks) was discontinued. Thus, when the requirement of
the amendment became operative, the overall minimum liquidity ratio of commercial
banks stood at 28 per cent (made up of 3 per cent of cash reserve and 25 per
cent liquid assets) as against the previous minimum of 20 per cent. By virtue of the
power to vary the cash reserves of scheduled banks with the Reserve Bank from
3 per cent to 15 per cent, their overall liquidity ratio may be pushed up to 40 per
cent. In the case of non-scheduled banks, however, since the cash balance of 3
per cent to be maintained under Section 18 of the Banking Regulation Act cannot
be varied, their overall liquidity remains at 28 per cent.
The effect of the amendment is to split up the overall liquidity requirement of
scheduled banks into two portions:
(i) statutory reserve balance required to be maintained under Section 42
of the Reserve Bank of India Act and
(ii) cash or till money, gold, excess over statutory reserves, balances with
the State Bank of India and with notified banks and unencumbered
securities. This splitting up became necessary in the light of the
experience of the Reserve Bank in respect of the operations of the
variable reserve requirements. It was observed that when additional
reserve requirements were imposed, scheduled banks implemented
this partly by liquidating government bonds. This tended to shift the
impact of varying the reserves intended to restrict bank credit in
particular to reducing investments in government securities. It was,
therefore, considered necessary to minimize the impact of any future
Self-Instructional
112 Material
action to raise reserve requirements on security holdings. The overall Banking Regulation
Act, 1949
liquidity requirements were also raised correspondingly.
(c) Capital Funds
The paid-up capital and reserves of commercial banks failed to keep pace with NOTES
the increase in deposits brought about by the growing economic activity, with the
result that the ratio of paid-up capital and reserves to deposits of scheduled banks
steadily declined from about 9 per cent in 1950 to less than 5 per cent in 1960.
The average ratio of capital funds to deposits was on the low side as compared to
the position in many other countries, where there had always been a concerted
effort to get the shareholders’ money in business into a proper trading relationship
to the deposits. Under Section 17 of the Banking Regulation Act, Indian banks
were required to transfer to reserves 20 per cent of their balance of profit until the
reserves together with the balance in the share premium account equalled with
paid-up capital. In terms of the present amendment, a banking company
incorporated in India is required to continue transferring to the reserve fund created
under Section 17 of the Act even if the reserves have already equalled paid-up
capital, out of the balance of profit each year, as disclosed in the profit and loss
account and before any dividend is declared, a sum equivalent to not less than 20
per cent of such profit. In respect of a foreign bank, Section 11 (2) of the Banking
Regulation Act prescribes that a sum of 15 lakh, or if it has a place or places of
business in Mumbai or Kolkatta or both 20 lakh, should be deposited with the
Reserve Bank in lieu of paid-up capital. In terms of the amendment to that section,
banking companies incorporated outside India are required to deposit with the
Reserve Bank, in addition to the deposits required to be maintained as aforesaid,
as soon as may be after the expiration of each calendar year, an amount calculated
at not less than 20 per cent of the profit for that year in respect of all business
transacted through the branches in India as disclosed in the profit and loss account
prepared with reference to that year.
The Central Government may, on the recommendation of the Reserve Bank,
and having regard to the adequacy of the paid-up capital and reserves in relation
to deposit liabilities in the case of Indian banks, and having regard to the adequacy
of the amounts deposited in relation to deposit liabilities in the case of foreign
banks, exempt them from transferring 20 per cent of their profits for a specified
period.
The amendment to Section 11 of the Banking Regulation Act raised the limit
of minimum paid-up capital in the case of an Indian banking company which
commences banking business for the first time after the commencement of the
Banking Companies (Amendment) Act, 1962 to 5 lakh irrespective of whether it
has only one place of business or places of business in only one state as against the
previous lowest minimum capital requirement of 50,000 which was fixed long
back and which in the light of the subsequent changes in economic conditions was
considered too low.
Self-Instructional
Material 113
Banking Regulation (d) Credit Information
Act, 1949
It was felt that in the absence of any regular and systematic arrangement for the
collection, pooling and supply of particulars relating to the loans and advances or
NOTES other credit facilities granted by the various banks and financial institutions to those
borrowing from them, individual banks or financial institutions were handicapped
in obtaining reliable information about the creditworthiness or financial position of
the various persons/institutions to whom credit had been or may have to be granted.
In order to enable the Reserve Bank to collect and supply the relevant information
in a consolidated form to the lending institutions, a new chapter has been introduced
to the Reserve Bank of India Act enabling the Reserve Bank to collect credit
information from banks and financial institutions and defining the functions of the
Reserve Bank in regard to the pooling, consolidation and publication of such
information.
(e) Export Finance
The Reserve Bank of India Act, 1934 did not generally permit the bank to make
any loans or advances or to grant financial accommodation in any other form to
commercial banks for periods in excess of 90 days. It was also not possible for
the bank to make any such accommodation on the security of documents bearing
only a single signature on behalf of any borrowing institution. It was appreciated
that these restrictions rendered it difficult for banks to extend to exporters credit
facilities for the periods for which, or on the conditions on which, such credit may
be required by them. In terms of the amended provisions:
(i) The period of maturity of eligible bills of exchange and promissory notes
which the Reserve Bank is authorized to purchase or rediscount or lend
against is increased from 90 days to 180 days of the bills of exchange or
promissory notes, as the case may be, relating to the export of goods from
India.
(ii) The Reserve Bank of India is authorized to grant loans to scheduled banks
or to State cooperative banks against the signature of the borrowing
institutions themselves, if the borrowing institutions furnish declarations to
the effect that they are holding and will continue to hold, so long as the
advances granted to them by the Reserve Bank remain outstanding, bills
drawn by Indian exporters on foreign countries maturing within 180 days,
the amount of which will not be less than the amount of outstanding loans
and advances.
(iii) The Reserve Bank is authorized to grant normal banking accommodation
to the scheduled banks and State cooperative banks for 180 days if the
accommodation is for the purpose of financing exports.
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114 Material
The Banking Laws (Miscellaneous Provisions) Act, 1963 Banking Regulation
Act, 1949
With a view to restrain the control exercised by particular groups or persons over
the affairs of banks and to providing for stricter control over banks by the Reserve
Bank, the Banking Laws (Miscellaneous Provisions) Act was passed in 1963. NOTES
The Act amends the Reserve Bank of India Act, the Banking Regulation Act and
the State Bank of India (Subsidiary Banks) Act. The Act empowers the Reserve
Bank to supervise, control and regulate the activities of institutions carrying on the
business of accepting deposits or any other business allied to banking. The details
of these provisions are given below:
A new chapter has been introduced in the Reserve Bank of India Act,
empowering it to regulate or prohibit the issue of any prospectus or advertisement
by non-banking institutions soliciting deposits from the public and call for returns
and information from such institutions relating to deposits received by them. The
non-banking institutions include companies, corporations and firms. The Reserve
Bank is also empowered to give directions to non-banking institutions in regard to
the receipt of deposits, including the rates of interest payable on such deposits and
the periods for which deposits may be received. If any non-banking institution fails
to comply with any direction given by the Reserve Bank, the bank may prohibit
the acceptance of deposits by that institution. The bank may also require a non-
banking institution receiving deposits from the public to send a copy of its annual
balance sheet and profit and loss account to every person whose deposits with the
institution as on the last day of the accounting year exceeds the sum specified by
the Reserve Bank.
The Reserve Bank is further empowered to:
(i) call from financial institutions information or statements relating to their
business, including information in respect of paid-up capital, reserves
or other liabilities, investments made and advances granted by them
and
(ii) give directions to such institutions relating to the conduct of their
business. In this connection, ‘financial institution’ means any non-
banking institution which carries:
 on as its business or part of its business the financing of trade,
industry, commerce or agriculture or
 on as its business or part of its business the acquisition of shares,
stocks, bonds, debentures or debenture stock or securities issued
by a government or local authority, or other marketable securities
of like nature or
 on as its principal business hire purchase transactions or the
financing of such transactions.
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Banking Regulation The bank is also empowered to inspect any non-banking institution and its
Act, 1949
books and accounts for the purpose of verifying the correctness or completeness
of any statement or information furnished by it or for the purpose of obtaining
information or particulars which such institution has failed to furnish on its being
NOTES called upon to do so. The Act provides penalties for persons and institutions for
failure to comply with the directions of the Reserve Bank and for wilful submission
of incorrect information to the Reserve Bank.
Certain amendments in regard to procedural matters have also been made.
These relate to the suspension of the provision that currency notes, if not presented
for payment within 40 years after the date of issue, would be deemed to have
gone out of circulation and that the value of rupee coins, including one rupee notes
held as assets in the Issue Department of the Reserve Bank, should not be less
than 50 crore or one-sixth of the total assets held in the Issue Department,
whichever was higher.
The Act amends the Banking Companies Act, 1949 with a view to providing
further powers to the Reserve Bank so as to ensure stricter supervision and control
over the commercial banks. Section 10 of the Principal Act has been amended so
that the term of office of a person managing the affairs of a bank cannot, at any
one time, be in excess of five years. The Act also provides that renewal of contract
cannot be sanctioned earlier than two years from the date on which it is to come
into force. If the term of office of any person managing the affairs of the bank is for
an indefinite period, it should come to an end immediately on the expiry of five
years from the date of his appointment or on the expiry of three months from the
date of commencement of the amendment, whichever is later.
The amendment Act reduced the maximum voting rights of individual
shareholders of a banking company from 5 per cent to 1 per cent of the total
voting rights of all the shareholders of that company.
Amendments to Section 20 prohibit the grant of unsecured loans by a banking
company to any company in which the Chairman of the Board of Directors of the
banking company appointed for a fixed term is interested as the Chairman or
Managing Director of the company or as the managing agent or director or partner
of the managing agent of such company. These restrictions do not, however, apply
to the granting of advances by a banking company against trust receipt or against
bills for supplies for services made or rendered to government or bills of exchange
arising out of bonafide commercial or trade transactions.
The Act further provides that a banking company shall not, without the
approval of the Reserve Bank, remit any debt due to it by any of its directors or
by any company or firm in which any of its directors, managing agent or guarantor,
or by any individual if any of the directors is his partner or guarantor.
Section 21 of the principal Act has been amended so as to extend the
powers of the Reserve Bank to give directions to banks regarding the maximum
amount of advances that may be granted or the maximum amount up to which
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guarantees may be given on behalf of any one company, firm, association of persons Banking Regulation
Act, 1949
or individual.
Under the existing legislation, there was no provision for the Reserve Bank
to remove a person connected with the management of a banking company except
NOTES
as a sequel to contravention by him of any law, or to make appointment directly on
its own initiative to the post of a director or chief executive officer of a banking
company. In order to strengthen the power of the Reserve Bank in this regard, a
new section has been introduced in the principal Act, under which the bank can,
by an order in writing, remove any person associated with the working of a banking
company, whether or not that person has been found to have contravened the
provisions of any law, or the Reserve Bank considers it necessary or desirable
either in the public interest or in the interest of the depositors or for the better
management of the banking company. The Reserve Bank may also appoint a
suitable person in place of the person removed from office. A person proposed to
be removed from office will, however, be given reasonable opportunity of making
a representation to the Reserve Bank against his removal. In case the bank feels
that any delay would be detrimental to the interests of the banking company or its
depositors, it may, at the time of giving the opportunity, or at any time thereafter,
direct that pending consideration of the representation the person concerned shall
not take any part in the management or working of the banking company. Any
person against whom an order for removal from office is made by the Reserve
Bank will have the right to prefer an appeal to the Central Government, within 30
days from the date of the order. A new section has also been included in the
Banking Regulation Act conferring on the Reserve Bank the power to appoint, for
a period up to three years at a time, one or more additional directors in the case of
a banking company, provided that such additional directors shall not exceed five
or one-third of the maximum strength of directors, excluding the additional directors
appointed by the Reserve bank, of the company fixed by its Articles, whichever is
less.
The following are the other amendments:
(i) The prohibition on the use of any of the words ‘bank’, ‘banking’ or
‘banking company’ hitherto applicable to a company other than a
banking company under Section 7 of the Act has been extended to
firms, individuals or groups of individuals.
(ii) The amendment to Section 34–A extends to all banking companies
the benefit of protection of the secrecy of information regarding their
inner or undisclosed reserves, which was hitherto available only to
banking companies with offices in more than one state.
(iii) The amendment to Sections 44–A and 45, relating to the voluntary
amalgamation sanctioned by the Reserve Bank or the compulsory
reconstruction and/or amalgamation of banking companies under the
order of the Central Government, makes it clear that the orders of
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Banking Regulation sanction passed by the Reserve Bank or the Central Government, as
Act, 1949
the case may be, will be conclusive evidence as to the fulfilment of all
requirements of law relating to reconstruction and/or amalgamation,
and that copies of such order duly certified by an officer of the Reserve
NOTES Bank or the Central Government, as the case may be, shall in all legal
proceedings, be admitted as evidence to the same extent as the original
orders.
An important and growing element in the overall banking system, namely
cooperative banks, was brought within the ambit of the Reserve Bank’s statutory
control under the Banking Laws (Application to Cooperative Societies) Act which
came into force from 1 March 1966.
The Act extends to State Cooperative Banks, Central Cooperative Banks
and the more important primary non-agricultural credit societies including, in
particular, Urban Cooperative Banks, the provisions of the Reserve Bank of India
Act and the Banking Companies Act, except those relating to incorporation,
management and winding-up which will continue to be governed by the State
Cooperative Societies Acts.
The amendments to the Reserve Bank of India Act make State cooperative
banks eligible to be included in the second schedule, with its attendant privileges
and obligations. Further, all cooperative banks to which the provisions of the
Reserve Bank of India Act have been extended are now eligible to borrow in an
emergency from the Reserve Bank. The more important among the provisions of
the Banking Regulation Act which are applicable to cooperative banks are those
in regard to the maintenance of reserves, liquid assets, control on advances,
licensing, inspection and issue of directives. A cooperative bank other than a
scheduled state cooperative bank has to maintain under Section 18 of the Banking
Regulation Act a cash reserve of not less than 3 per cent of its total demand and
time liabilities either with itself or in current account with the higher financing agencies.
Under Section 24 of the Act, all cooperative banks are required to maintain liquid
assets, including the minimum cash reserve of 3 per cent, of not less than 20 per
cent of the total time and demand liabilities in India, for a period of two years from
the commencement of the Act or for such further period not exceeding one year
as the Reserve Bank may allow in a particular case. This is in the nature of a
transitional provision, for thereafter all the cooperative banks will have to maintain,
as commercial banks are required to do, liquid assets of not less than 25 per cent
of total time and demand liabilities, in addition to the cash reserve of 3 per cent.
The borrowings of the cooperative banks from their higher financing agencies are
excluded from the computation of time and demand liabilities.
Under Section 20 of the Act, cooperative banks are prohibited from granting
unsecured advances to the directors, but the Reserve Bank is empowered to
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allow primary cooperative banks to grant, if necessary, to their directors unsecured Banking Regulation
Act, 1949
loans and advances on such terms and conditions as may be approved by it.
Section 21 of the Act empowers the Reserve Bank to issue directives to
cooperative banks or any of them regarding the terms and conditions on which
advances and guarantees may be given by them. This section, incidentally, confers NOTES
on the Reserve Bank the power to extend the various selective credit controls to
the operations of the cooperative banks. Under Section 22 of the Act, all existing
cooperative banks are required to apply to the Reserve Bank for a licence within
a period of three months from the commencement of the Act. Such banks will be
permitted to carry on banking business if licences are granted to them or until they
are informed by the Reserve Bank that a licence cannot be granted to them. A new
cooperative bank will be required to obtain a licence before the commencement
of banking business. Section 23 of the Act has conferred on the Reserve Bank
powers to licence the opening of branches so as to bring about a proper
coordination between the branch expansion programmes of commercial banks
and cooperative banks. Section 35 of the Act empowers the Reserve Bank to
inspect the cooperative banks either directly or through state cooperative banks.
Deposit Insurance Corporation Act, 1962
The main object of the Deposit Insurance Corporation Act is to give a measure of
protection to depositors, especially small depositors, against the risk of losing
their savings in the event of a bank’s inability to meet its liabilities and thereby
assist banks in mobilizing deposits. An assurance of the safety of funds also assists
in the active development of the banking habit of the community, reduces the
occurrence of panicky withdrawals of deposits with banks and generally contributes
to the stability and orderly growth not only of the individual banks but also
collectively of the banking system.
The Deposit Insurance Corporation has an authorized capital of 1 crore
which is fully paid-up by the Reserve Bank of India. The Act, under Section 26,
empowers the corporation to borrow from the Reserve Bank up to a maximum of
5 crore. In order to obtain a clear picture of the net balance of the results of the
insurance operations, the Act requires the corporation to maintain a separate
Deposit Insurance Fund. To this fund would be credited:
(a) all amounts received by the corporation as premium;
(b) all amounts received by the corporation from the liquidator;
(c) all amounts transferred to that fund from the general fund;
(d) the amounts advanced by the Reserve Bank and
(e) all income arising from the investments made out of that fund.
In addition, the corporation would maintain a general fund, built-up with the
capital and reserves as well as income accruing from the investment of those funds,
after meeting the working expenses of the corporation. If at any time the amount
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Banking Regulation available in the Deposit Insurance Fund is insufficient to meet the requirements of
Act, 1949
the fund, the corporation may transfer from the general fund such amount as may
be necessary to meet the requirements of the Deposit Insurance Fund on such
terms and for such periods as may be determined by the Board with the approval
NOTES of the Reserve Bank. (Section 27)
The Deposit Insurance Fund would be applied:
(a) to make payments in respect of insured deposits;
(b) to meet liabilities in respect of an advance taken from the Reserve
Bank under Section 26 and
(c) to meet liability in respect of the amounts transferred to the Deposit
Insurance Fund from the general fund under Section 27.
The corporation is required to invest its funds only in Central Government
securities and treat the Reserve Bank as its sole banker.
Management of the Corporation
The general superintendence, direction and management of the affairs of the
corporation are vested in a Board of Directors, consisting of:
(a) the Governor for the time being of the Reserve Bank, who is the Chairman
of the Board;
(b) a Deputy Governor of the Reserve Bank nominated by the bank;
(c) an officer of the Central Government nominated by that government;
(d) two directors nominated by the Central Government in consultation with
the Reserve Bank, having special knowledge of commercial banking or of
commerce, industry or finance, neither of whom is an officer of the
government or of the Reserve Bank or an officer or other employee of the
corporation or a director, an officer or other employee of a banking company
or actively connected with a banking company.
The term of office of the first three directors is fixed by the respective
authorities nominating them. The term of office of the non-official directors is limited
to four years.
A person is not capable of being nominated as a director if:
(a) he has been removed or dismissed from the service of government or
of a corporation or a company in which not less than 51 per cent of
the paid-up share capital is held by the government;
(b) he is or at any time has been adjudged an insolvent or has suspended
payment of his debts or has compounded with his creditors;
(c) he is of unsound mind and stands so declared by the Court and
(d) he has been convicted of any offence which, in the opinion of the
Central Government, involves moral turpitude.
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The day-to-day affairs of the corporation are entrusted to an Executive Banking Regulation
Act, 1949
Committee constituted by the Board from among its members and consisting of
such number of directors as may be prescribed by the Board. The Act requires
the corporation in matters of policy involving public interest as the Central
Government may, after consulting the Reserve Bank, give to it in writing. NOTES
Registration of Banking Companies as Insured Banks and Liability

of the Corporation to Depositors
In terms of the Act, banks which are already licensed are not refused a licence and
those which are notified as banks under Section 51 of the Banking Regulation Act,
viz., the State Bank of India and its subsidiaries, functioning at the time when the
Act came into force were to be registered as insured banks. All new banks
commencing operations in future would also have to be registered as insured banks.
The registration of a banking company as an insured bank shall stand
cancelled on the occurrence of any of the following events, namely:
(a) if it has been prohibited from accepting fresh deposits or
(b) if it has been informed in writing by the Reserve Bank that its licence
has been cancelled under Section 22 of the Banking Regulation Act,
or that a licence under the Section cannot be granted to it or
(c) if it has been ordered to be wound-up or
(d) if it has transferred all its deposit liabilities in India to any other institution
or
(e) if it has ceased to be a banking company within the meaning of
subsection (2) of Section 36–A of the Banking Regulation Act, or has
converted itself into a non-banking company or
(f) if a liquidator has been appointed in pursuance of a resolution for the
voluntary winding up of its affairs or
(g) if in respect of it any scheme of compromise or arrangement of
reconstruction has been sanctioned by any competent authority and
the said scheme does not permit the acceptance of fresh deposits or
(h) if it has been amalgamated with any other banking institution.
Section 16 of the Act lays down the liability of the corporation in respect of
insured deposits. In terms of this section:
1. ‘Where an order for the winding-up or liquidation of an insured bank
is made, the corporation shall, subject to the other provisions of this
Act, be liable to pay every depositor of that bank in accordance with
the provisions of Section 17 an amount equal to the amount due to
him in respect of his deposit in that bank at the time when such order
is made:
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Banking Regulation Provided that the liability of the corporation in respect of an insured
Act, 1949
bank shall be limited to the deposits as on the date of the cancellation
of registration;
Provided further that the total amount payable to any one depositor
NOTES
in respect of his deposit in that bank in the same capacity and in the
same right shall not exceed 1,500;
Provided further that the corporation may, from time to time, having
regard to its financial position and to the interests of the banking system
of the country as a whole, raise, with the previous approval of the
Central Government, the aforesaid limit of 1,500.
2. Where in respect of an insured bank a scheme of compromise or
arrangement of reconstruction or amalgamation has been sanctioned
by any competent authority and the said scheme provides for each
depositor being paid or credited with, on the date on which the scheme
comes into force, an amount which is less than the original amount
and also a specified amount, the corporation shall be liable to pay
every such depositor in accordance with the provisions of Section 18
an amount which is equal to the difference between the amount so
paid or credited and the original amount, or the difference between
the amount so paid or credited and the specified amount, whichever
is less—
Provided that where any such scheme also provides that any payment
made to a depositor before coming into force the scheme shall be
reckoned towards the payment due to him under that scheme shall be
deemed to have provided for that payment being made on the date of
its coming into force.
3. For purpose of this section, the amount of a deposit shall be determined
after deducting therefrom any ascertained sum of money which the
insured bank may be legally entitled to claim by way of set-off against
the depositor in the same capacity and in the same right.’
Thus, according to the Act, the amount of insurance cover provided by the
corporation originally was 1,500 in respect of each depositor in each bank, in
the same capacity and in the same right. However, deposits of the Central and
state governments, foreign governments and banking companies were not covered
by the scheme. With Effect from 1 April 1967, the Corporation increased the limit
of insurance cover from 1,500–5,000. It was further increased 10,000 with
effect from 1 April 1970; to 20,000 with effect from 1 July 1980 and to 1,00,000
with effect from 1 May 1993. This enhanced insurance cover of 1,00,000 will
apply in the case of any liquidation or winding-up of an insured bank on or after 1
May 1993, and compromise or arrangement of reconstruction or amalgamation
of an insured bank sanctioned on or after that date not providing for payments of
amounts due to its depositors.
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The Act sets out in detail the manner of payment by the corporation in the Banking Regulation
Act, 1949
event of an insured bank ceasing to function. It sets a definite time limit within
which the corporation should make payment to the depositors, namely five months
from the date of winding-up of a bank. In terms of Section 17 of the Act:
NOTES
1. ‘Where an insured bank has been ordered to be wound-up or taken
into liquidation and a liquidator, by whatever name called, has been
appointed in respect thereof, the liquidator shall, with the least possible
delay and in any case not later than three months from the date of his
assuming charge of office, furnish to the corporation a list in such form
and manner as may be prescribed by the corporation showing separately
the deposits in respect of each depositor and the amounts of set-off
referred to in subsection (3) of Section 16.
2. Before the expiry of two months from the receipt of such list from the
liquidator, the corporation shall pay to each depositor of the insured
bank in respect of his deposit the amount payable under Section 16
either directly or through the liquidator or through any other agency as
the corporation may determine.’
Where a scheme of compromise or arrangement of reconstruction or
amalgamation has been sanctioned for an insured bank, the bank concerned or
the transferee bank in the case of amalgamation should furnish to the corporation
a list showing separately deposits of each depositor, if any, and the amount paid or
credited to his accounts under the scheme. Within three months from the receipt of
such list, the corporation is required to make the payment to the depositors (Section
18). The corporation, of course, is entitled to reimburse itself for such payment
from the assets of the insured bank.
Payment of Premium by an Insured Bank
Section 35 of the Act lays down:
1. ‘Every insured bank shall, so long as it continues to be registered, be liable
to pay a premium to the corporation on its deposits at such rate or rates as
may, with the previous approval of the Central Government, be notified by
the corporation in the Official Gazette from time to time—
Provided that premium payable by any insured bank for any period shall
not exceed fifteen paisa per annum for every hundred rupees of the total
amount of the deposits in that period or where its registration has been
cancelled during that period, on the date of its cancellation;
Provided further that where the registration of any insured bank is cancelled
under Section 13, such cancellation shall not affect the liability of that bank
for payment of premium for the period before such cancellation and of any
interest due under the provisions of this section.
2. The premium shall be payable for such periods, at such times and in such
manner as may be prescribed.
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Banking Regulation 3. If an insured bank makes any default in payment of any amount of premium,
Act, 1949
it shall, for the periods of such default, be liable to pay to the corporation
interest on such amount at such rate not exceeding eight per cent per annum
as may be prescribed.’
NOTES
Thus, the maximum premium which the corporation is empowered to charge
the insured banks is 15 paisa per annum for every 100 of the total amount of
deposits with the bank (excluding the deposits by the Central and state governments,
a foreign government or a banking company). The premium payable by the insured
banks on their assessable deposits has been marginally raised from four paisa to
five paisa per 100 per annum with effect from 1 July 1993.
Inspection of Insured Banks
In terms of Section 36 of the Act:
1. ‘The corporation may for any of the purposes of this Act request the Reserve
Bank to cause an inspection of the books and accounts or an investigation
of the affairs of an insured bank to be made and on such request the Reserve
Bank shall cause such inspection or investigation to be made by one or
more of its officers.
2. The provisions of subsection (2) and subsection (3) of Section 35 of the
Banking Companies Act, 1949 shall apply to an inspection or investigation
under subsection (1) as they apply to an inspection under that section.
3. When an inspection or investigation has been made under this section, the
Reserve Bank shall furnish a copy of its report to the corporation. Neither
the bank inspected or investigated, nor any other bank shall be entitled to
be furnished with a copy of such report.
4. Notwithstanding anything contained in any law for the time being in force,
no court, tribunal or other authority shall compel the production or disclosure
of a report under this section or of information or material gained during the
course of an inspection or investigation under this section.’
Further in terms of Section 38, the Reserve Bank shall, on a request in
writing from the corporation, furnish to it any report or information relating to an
insured bank made or obtained by it under or in pursuance of the Reserve Bank of
India Act or the banking Regulation Act.
The Act also empowers the corporation to ask insured banks to furnish any
information relating to their deposits and to have free access to any of their records
which it considers necessary. The relevant provisions are laid down in Sections 34
and 35 of the Act.
Deposit Insurance and Cooperative Banks
At the time of launching the system of deposit insurance itself, the exclusion of
cooperative banks from the scope of the scheme was pointed out as a shortcoming.
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In fact, at the time of introducing the Deposit Insurance Corporation Bill in the Banking Regulation
Act, 1949
Lok Sabha, a suggestion had been made that the cooperative banks should be
brought within the scope of the scheme. But it was stated that as the cooperative
banks were exempted from the provisions of the Banking Companies Act they
were not subject to the same degree of control as the commercial banks and NOTES
hence there would be practical difficulties in extending the scheme to cooperative
banks.
Subsequently, the cooperative banks were brought within the ambit of the
Reserve Bank’s statutory control under the Banking Laws (Application to
Cooperative Societies) Act which came into force from 1 March 1966. With a
view to extending the scheme of Deposit Insurance to cover State and central
cooperative banks and the larger primary non-agricultural credit societies, i.e.,
urban cooperative banks with paid-up capital of 1 lakh or more, the Deposit
Insurance Corporation (Amendment) Act was passed in 1968.
Complaints against the Scheme
Although there cannot be two opinions as to the effectiveness of deposit insurance
in safeguarding the interests of the depositors and in avoiding panicky withdrawals,
certain quarters have raised a few opposing arguments to it.
In the first place, it is argued that the ceiling limit will cause disintegration of
accounts. Since protection is available, most depositors, especially the small and
medium depositors, will try to take full advantage of it by depositing only the
minimum with any particular bank. Against this, it is pointed out that the ceiling limit
alone will not induce a person to keep deposits with a number of banks in order to
get full protection. Moreover, whatever might have been the validity of this criticism
at the time of launching the scheme, it may be noted that the ceiling limit has been
considerably raised from 1,500–1,00,000.
Another complaint, and closely related to the previous one, is that the limited
insurance cover will place the bigger banks in a disadvantageous position as
compared to the smaller units. This is because they are also called upon to pay
premia on the total deposits. However, one should not forget that the bigger units
benefit indirectly in that a system of deposit insurance promotes a sound banking
system and avoids panicky withdrawals consequent on the failure of the smaller
units. The heavy withdrawals experienced by one of the ‘Big Five’ of India
consequent on the failure of the Palai Central Bank is a clear case in point. However,
it is advisable for the Deposit Insurance Corporation of India, as in the case of the
Federal Deposit Insurance Corporation of America, to adopt a refund system of
the premia at the end of each year from the surplus that remains with the corporation
after taking into account the total cost of operation including administrative expenses,
net addition to reserves and insurance losses. A deviation from the American system
of applying this surplus against assessment for the following year is on a pro rata
basis. Instead, in India, refund may be made on the basis of premia paid by the
banks on uninsured deposits. This will reduce the grievance of the bigger banks.
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Banking Regulation Another criticism is that the Act does not confer direct power of inspection
Act, 1949
on the corporation. Of course, it can direct an insured bank to furnish to it such
statements and information relating to the deposits as the corporation may consider
necessary. As regards inspection, it can only request the Reserve Bank to cause
NOTES an inspection and furnish it with copies of the inspection reports. Certainly this
avoids duplication of work. Nevertheless, it would be better if the corporation is
given direct authority to inspect the insured banks. This need not necessarily mean
that the corporation should conduct regular inspections. In special cases, as in the
case of FDIC of America, the corporation will then be enabled to gather first hand
information.
A recent suggestion in certain quarters is that since the bigger commercial
banks have already been brought under the public sector, there is not much meaning
in continuing the scheme any further. It is true that these banks along with the State
Bank of India group command a sizeable proportion of the banking resources in
the country at present. But this suggestion does not carry much weight in the light
of the establishment of the new private sector banks and the local area banks as a
result of the recent banking reforms.
Deposit Insurance and Credit Guarantee Corporation
With the merger of the Credit Guarantee Corporation of India with the Deposit
Insurance Corporation in 1978, the Deposit Insurance Corporation has been
renamed as the Deposit Insurance and Credit Guarantee Corporation (DICGC).
In this connection, the reader’s attention is invited to the section ‘Credit Guarantee
Scheme for Small Borrowers’ dealt with in the chapter ‘Commercial Banks and
Industrial Finance.’
Economic Importance of Deposit Insurance
The economic importance of deposit insurance stems from the fact that the liabilities
of banks are essentially to demand liabilities to the public. These liabilities constitute
the country’s principal means of payment, i.e., cheque money. Distress calling of
loans with forced liquidation of securities by banks and bank borrowers has led to
widespread bank suspensions and to a drastic destruction of the principal part of
money supply, bank deposits.
Deposit insurance is useful in correcting these unfortunate periodic
experiences from two major closely related viewpoints—that of the individual and
that of the nation. From the individual’s standpoint, deposit insurance provides
protection, within limits, against the banking hazards of deposit ownership. But
the major virtue of deposit insurance is for the nation as a whole. By assuring the
public, individuals and businesses alike, that cash in the form of bank deposits is
insured up to a prescribed maximum, a major cause of instability in the nation’s
money supply is removed.
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The guarantee of the kind envisaged and the assurance of immediate payment Banking Regulation
Act, 1949
in the event of loss tend to encourage the banking habit particularly from the point
of view of the small savers who generally deal with relatively smaller institutions.
At the same time, the fact should not be overlooked that the successful
NOTES
working of a scheme of deposit insurance depends to a large extent on the
supervision of the insured banks and the efforts of the banks themselves towards
improving their standard of operation. Deposit insurance should not be considered
as a panacea curing all ills of the banking organism. No doubt, a system of deposit
insurance would make a significant contribution in the direction of eliminating chain
reactions of runs by instilling confidence in the minds of the depositors. But it must
be properly supplemented with other measures to get the desired results.
Deposit Insurance Reform
Consequent upon the changes made in the operation of the three Credit Guarantee
Schemes operated by the DICGC, a large number of banks have opted out of the
Credit Guarantee Scheme. While the viability of the Corporation in relation to
credit guarantee has come into focus, there may be need for an alternative
arrangement.
With the gradual deregulation of interest rates on advances to priority sector,
a re-look into the role and functions of the DICGC has become necessary.
Simultaneously, reforming the deposit insurance system is a crucial component of
the present phase of financial sector reforms in India. Accordingly, the Reserve
Bank set up a Study Group on Reforms in Deposit Insurance in India under the
Chairmanship of Shri Jagdish Capoor. The terms of reference of the working
group included:
(a) to review the role of deposit insurance in financial sector and economic
developments, including a review of the international experience with
regard to deposit insurance;
(b) to conduct a detailed survey of the nature of deposit insurance in
India—instruments, institutions and legal framework and
(c) to propose changes in the existing system.
The group submitted its report in October 1999. The major recommendations
of the group include:
(a) fixing the capital of Deposit Insurance and Credit Guarantee
Corporation at 500 crore, to be contributed fully by the Reserve
Bank;
(b) withdrawing the function of credit guarantee on loans from DICGC;
and
(c) risk-based pricing of the deposit insurance premium in lieu of the present
flat rate system.
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Banking Regulation In relation to the third recommendation mentioned above, it may be noted
Act, 1949
that in India, at present, the deposit insurance premium is a flat rate, irrespective of
the risk profile of the financial entity concerned. This creates a moral hazard problem
in that depositors have limited incentive to monitor the condition of the financial
NOTES institution. This has raised the obvious question as to whether the premium should
be risk-based which requires establishment of an agreeable basis of assessment
of risk profile of banks. Various alternate choices such as Federal Deposit Insurance
Corporation model of supervisory rating (CAMELS), risk-adjusted assets basis
and option pricing model exist. There is also the question whether the onus of
monitoring the bank should fall on the Deposit Insurance Corporation and whether
it should be conferred legal status to take penal action including liquidation. Another
issue relates to the size of deposit that is insured. From the point of view of legal
requirements, the scope of revision of the present deposit insurance set up will
have to deal with a number of statutory amendments. Several enactments, including
the Bank Nationalization Act and the State enactments on cooperatives present
difficulties for the Deposit Insurance Corporation to act as a receiver/liquidator in
the case of failure of an insured entity.
Keeping all the issues in mind, a revised deposit insurance scheme is being
contemplated. The task of preparation of a new draft law has already been taken
up in supersession of the existing law.
Conclusion
The number of registered insured banks as at March 2011 was 2217 comprising
82 commercial banks, 82 regional rural banks, 4 local area banks and 2049 co-
operative banks. With the present limit of deposit insurance at 1 lakh, the number
of fully protected accounts (977 million) as at March 31, 2011 constituted 93 per
cent of total number of accounts (1052 million) against the international benchmark
of 80 per cent. Amount-wise, insured deposits at 17,35,800 crore constituted
35 per cent of assessable deposits at 49,52,427 crore against the international
benchmark of 20– 40 per cent. At the current level, the insurance cover works
out to 1.63 times per capita GDP as on March 31, 2011 as against the international
benchmark of around 1 to 2 times per capita GDP prior to the financial crisis.
The Corporation builds up its Deposit Insurance Fund (DIF) through transfer
of its surplus, i.e., excess of income (mainly comprising premia received from
insured banks, interest income from investments and cash recovery of assets of
failed banks) over expenditure each year, net of taxes. This Fund is used for
settlement of claims of depositors of banks taken into liquidation/reconstruction/
amalgamation, etc. The size of DIF stood at 24,704 crore as on March 31,
2011, yielding a Reserve Ratio (DIF/insured deposits) of 1.4 per cent.
An assessment team comprising representatives of IADI and IMF visited
DICGC in end-September 2010 to undertake a field test of the Draft Assessment
Methodology for Core Principles for Effective Deposit Insurance Systems.
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According to the assessment of the team, DICGC is compliant or largely compliant Banking Regulation
Act, 1949
on all core principles. However, weaknesses in the overall insolvency framework
which are outside the control of the DICGC makes overall compliance with many
core principles limited. The report made several recommendations such as removing
insolvent cooperative banks from the system, obtaining deposit-specific information NOTES
from banks in a standard format, executing MoUs by DICGC with other deposit
insurers whose banks have a presence in India, granting DICGC an access to
‘fast-track’ source of funding from either Reserve Bank of India or Ministry of
Finance to provide funds needed for prompt depositor reimbursement, developing
a formal public awareness programme and establishing a reasonable target reserve
fund by DICGC. The Working Group on Reforms in Deposit Insurance, including
Amendments to DICGC Act is looking into the recommendations of the field test
team.
The Banking Laws (Amendment) Act, 1968

The Banking Laws (Amendment) Act which amends the Banking Regulation Act,
the Reserve Bank of India Act and the State Bank of India Act and which provides
for the extension of social control over banks came into force with effect from
February 1969.
The objectives of the amendments to the banking Regulation Act are mainly
to achieve an equitable distribution of the resources of the banking system in
conformity with the requirements of the country so that priority sectors receive
their due and particular clients or groups of clients are not favoured.
The Act has coined certain new expressions which have far reaching
significance. The terms ‘banking policy’ and ‘substantial interest’ are the most
important among these expressions.
‘Banking Policy’, as defined in the Act, means any policy specified from
time to time by the Reserve Bank in the interest of the banking system or in the
interest of monetary stability or sound economic growth having due regard to the
interest of the depositors, the volume of deposits and other resources of the bank
and the need for equitable allocation and the efficient use of these deposits and
resources. Thus, the term covers in a single phrase all the diverse matters like the
interests of depositors or of the banking system, monetary stability, sound economic
growth and equitable allocation and efficient use of resources. The widening of the
scope of Reserve Bank’s directives to cover the requirements of banking policy,
in Sections 21, 35–A, 36 and 36–AB of the Banking Regulation Act, has the
effect of enlarging the Reserve Bank’s power to issue directions to banks in regard
to the policy to be followed by them in making loans and advances, or generally
on any matter concerning the affairs of a bank, whether arising out of inspection or
otherwise, and in regard to the appointment of observers or additional directors
by the Reserve Bank.
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Banking Regulation Another important term in the Act is ‘Substantial Interest’. This is defined
Act, 1949
‘Substantial Interest’:
1. in relation to a company, means the holding of beneficial interest by an
individual or his spouse or minor child, whether singly or taken together,
NOTES
in the shares thereof, the amount paid-up on which exceeds 5 lakh or
5 per cent of the paid-up capital of the company, whichever is less;
2. in relation to a firm, means the beneficial interest held therein by an
individual or his spouse or minor child, whether singly or taken together,
which represents more than 5 per cent of the total capital subscribed by
all the partners of the said firm.
The idea of combining the interests in shares or partnership capital of any
person with those of his spouse and minor children is new, somewhat revolutionary
and it has been prompted by the prevalence or possibility of large scale abuses.
The following are the more important provisions of the Act having a bearing
on social control over banks:
1. Banks are required to reconstitute their Board of Directors, so that not
less than 51 per cent of the total number of members is persons having
special knowledge of or practical experience in certain fields such as
accountancy, agriculture and rural economy, small-scale industry,
cooperation, banking, economics, finance and law. The directors
representing these sectors should not have substantial interest in or be
connected as employee or manager with large or medium sized industrial
undertakings or trading or commercial concerns. Of these directors,
not less than two are to represent agriculture or rural economy,
cooperation and small-scale industry.
The object of this provision is to distinguish clearly between the majority
of ‘non-industrialist’ directors and the majority of the industrialists and
businessmen on the Boards of banks and to ensure that the majority
directors are not closely connected with any trade, industry or business
of their own.
2. The Act empowers the Reserve Bank to reconstitute the Board of
Directors of banks if the composition of the Board does not fulfil the
requirements of law and the bank does not comply with the directions
given by the Reserve Bank in this regard.
3. The Act requires every Indian bank to have a full time Chairman who is
a professional banker and possesses experience in finance, economics
or business administration. So long as he is the Chairman of a banking
company, he should not be a director of any company or a partner of
any trading or industrial business concern or should not have substantial
interest in any company or firm and should not be engaged in other
business or concern. The appointment, removal or termination of
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appointment of the Chairman, and the terms to be granted to him would Banking Regulation
Act, 1949
require approval of the Reserve Bank. The bank is also empowered to
remove from office a Chairman of a banking company and appoint a
suitable person, after giving a reasonable opportunity to the Chairman
and the bank to represent their case. NOTES
4. The Act prohibits the grant of any new loans and advances, whether
secured or unsecured, to directors or members of any committee or
Board appointed by the banks in India or to concerns in which they are
interested as partner, director, manager, employee or guarantor or in
which they hold substantial interest. Subsidiaries of banking companies,
government companies and non-profit making companies are exempted
from this provision. Any loan which has already been granted or granted
after the commencement of this section because of an earlier commitment
must be recovered within the period stipulated at the time of the grant of
the loan or advance or where no such period has been stipulated, before
the expiry of one year from the commencement of the Act. The Reserve
Bank may, however, in special cases extend the period up to three years.
5. The object of this provision is to eliminate the possibility of any abuse of
the position in a bank to obtain credit. Hereafter, the position of a person
as a director of a bank will not mean easy assistance from that bank.
The importance of this provision can be gauged from the fact that as at
the end of 1966, a total of 673 directors served on the Board of 85
banking companies and these held among themselves as many as 3021
directorships in companies registered under the Indian Companies Act,
including directorships held by them in banks. Further, 1583 non-banking
companies were connected with 72 Indian banks through a single
director; 177 non-banking companies were connected with 67 banking
companies through two or more directors.3 Thus, interlocking of
directorship in non-banking companies with individual banks was a
conspicuous feature of the Indian banking system.
6. The appointment, re-appointment or removal of the auditors of a banking
company requires the approval of the Reserve Bank. The bank is also
authorized to direct the auditors to conduct a special audit of any
transaction or class of transactions and to report.
7. The Reserve Bank’s powers to appoint directors or observers and to
issue directions to banks have been amplified. Such directions may
hereafter be issued not only in the interests of depositors or proper
management of the banking companies, but also in the interest of banking
policy.
8. In view of the special responsibilities of banks under the Negotiable
Instruments Act towards the depositors and the public in general, the
Act provides a new section which makes it unlawful to: (a) obstruct any
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Banking Regulation person from lawfully entering or leaving a bank’s office or from carrying
Act, 1949
on any business there; (b) hold within such office, demonstrations which
are violent or are calculated to prevent the transaction of normal business;
or (c) act in any manner calculated to undermine the confidence of the
NOTES depositors in the bank concerned. This provision will not, however, be
used to curtail normal and lawful trade union rights by the employees.
9. Under the Act, the Central Government is empowered to acquire the
business of any bank, if it fails more than once to comply with any
directions issued to it under Section 21 or Section 35–A of the Banking
Regulation Act in so far as such directions related to banking policy or if
the Central Government is satisfied that a banking company is being
managed in a manner detrimental to the interests of its depositors, or in
the interest of banking policy, or for the better provision of credit generally,
or of credit to any particular section of the community or in any particular
area. Provision has been made for payment of compensation in the event
of such acquisition.
In consonance with the spirit of the above provisions, all foreign banks
operating in India have been asked to set up advisory boards consisting of Indians
(with the exception of the Chief Executive Officer when he is a member) with a
majority of persons having special knowledge of or practical experience in one or
more of the fields mentioned above.
Since the incorporation, regulation or winding up of cooperative banks are
governed by state laws, the various new provisions of the Act regarding
management, business, auditors or acquisition of banks do not apply to cooperative
banks.
Check Your Progress

1. Which powers does Section 21 of the Banking Regulations Act confer on
the Reserve Bank of India?
2. What does the Banking Companies (Second Amendment) Act, 1960 invest?
3. What is the main objective of the Deposit Insurance Corporation Act?

QUESTIONS
1. Section 21 of the Banking Regulations Act confers powers on the Reserve

Bank of India to determine the policy in relation to advances to be followed
by banking companies.
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132 Material
2. The Banking Companies (Second Amendment) Act, 1960 invests the Banking Regulation
Act, 1949
Reserve Bank and the government with additional powers aimed at
rehabilitation of banks’ difficulties.
3. The main object of the Deposit Insurance Corporation Act is to give a
NOTES
measure of protection to depositors, especially small depositors, against
the risk of losing their savings in the event of a bank’s inability to meet its
liabilities and thereby assist banks in mobilizing deposits.
7.4 SUMMARY
 The enactment of the Banking Regulation Act in 1949 has been a milestone
in the history of Indian joint stock banking.
 Section 6 of the Act lays down specifically the forms of business in which
banking companies may engage. The forms of business specified are in
consonance with accepted banking principles.
 Section 7 of the Act, as amended in 1963, prohibits the use of any of the
words ‘bank’, ‘banking’ or ‘banking company’ to a company other than a
banking company, or firms, individuals or group of individuals.
 Section 21 of the Act confers powers on the Reserve Bank of India to
determine the policy in relation to advances to be followed by banking
companies.
 The Banking Companies (Amendment) Act, 1960 inserts a new Section 34
A in the Banking Regulation Act to make it clear that information, which
according to law is not required to be published in the balance sheet or
profit and loss account of a banking company, need not be disclosed to the
authorities set up under the Industrial Disputes Act.
 The Banking Companies (Second Amendment) Act, 1960 invests the
Reserve Bank and the government with additional powers aimed at
rehabilitation of banks’ difficulties.
 The rehabilitation of a bank in difficulties would require a reasonable period
of investigation and negotiation into its position.
 The Reserve Bank of India (Amendment) Act, 1962 and the Banking
Companies (Amendment) Act, 1962 have come into force in September
1962.
 Section 42 of the Reserve Bank of India Act, which stipulates cash reserves
of scheduled banks to be kept with the Reserve Bank, has been simplified
to require scheduled banks to maintain with the Reserve Bank an average
daily balance of 3 per cent of their total time and demand liabilities.
 The liquidity ratio of scheduled banks showed a sizeable decline from around
43 per cent in 1950 to around 33 per cent in 1961.
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Banking Regulation  With a view to restrain the control exercised by particular groups or persons
Act, 1949
over the affairs of banks and to providing for stricter control over banks by
the Reserve Bank, the Banking Laws (Miscellaneous Provisions) Act was
passed in 1963.
NOTES
 With the merger of the Credit Guarantee Corporation of India with the
Deposit Insurance Corporation in 1978, the Deposit Insurance Corporation
has been renamed as the Deposit Insurance and Credit Guarantee
Corporation (DICGC).
 The economic importance of deposit insurance stems from the fact that the
liabilities of banks are essentially to demand liabilities to the public.
 Deposit insurance is useful in correcting these unfortunate periodic
experiences from two major closely related viewpoints—that of the individual
and that of the nation.
 The Banking Laws (Amendment) Act which amends the Banking Regulation
Act, the Reserve Bank of India Act and the State Bank of India Act and
which provides for the extension of social control over banks came into
force with effect from February 1969.
7.5 KEY WORDS
 Insurance: Insurance is a contract, represented by a policy, in which an

individual or entity receives financial protection or reimbursement against
losses from aninsurance company.
 Deposit: Deposit refers to a sum payable as a first instalment on the purchase
of something or as a pledge for a contract, the balance being payable later.
 Liabilities: A liability is defined as a company’s legal financial debts or
obligations that arise during the course of business operations.
 Amendment: An amendment is a formal or official change made to a law,
contract, constitution, or other legal document.

EXERCISES
1. Write a short note on the Banking Regulation Act.
2. What are some of the main reasons for the failure of banks in the past?
3. What was the main purpose of the Banking Companies (Amendment) Act,
1960?
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134 Material
4. State the main purpose of Banking Laws (Application to Cooperative Banking Regulation
Act, 1949
Societies) Act, 1966.
1. What are the important provisions of the Banking Regulation Act? Discuss. NOTES
2. State the powers that the Banking Regulation Act confer on the Reserve
Bank of India to control the bank companies.
3. Discuss the salient features of the amendments to the Reserve Bank of
India Act.
4. What are the main powers of the Reseerve Bank of India? Explain.

Delhi.
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Material 135
Indian Banking
UNIT 8 INDIAN BANKING

NOTES Structure
8.0 Introduction
8.1 Objectives
8.2 Reserve Bank of India: Organization, Management and Functions
8.2.1 Management and Structure
8.2.2 Major Functions of RBI
8.3 NABARD
8.5 Summary
8.6 Key Words
8.0 INTRODUCTION
Indian banking system is a prerogative of establishing milestones and flexibility.

The RBI along with other banks help to regulate the monetary exchanges, debts
and loans. Apart from these, indigenous banks also aid the overall banking structure.
By far the most important constituent of the bazar money market is the indigenous
banker. The Central Banking Enquiry Committee defines indigenous bankers as
all bankers other than the Imperial Bank of India, the Exchange Banks, the joint
stock banks and the co-operative societies and includes any individual or private
firm receiving deposits and dealing in hundis and lending money.
8.1 OBJECTIVES

 Understand the organization of the RBI
 Discuss the management and structure of the RBI
 Learn about NABARD, Commercial Banks, Indigenous Banks and
Cooperative Banks
8.2 RESERVE BANK OF INDIA: ORGANIZATION,

MANAGEMENT AND FUNCTIONS
Let us analyse the management, structure and functions of RBI.

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8.2.1 Management and Structure Indian Banking
The Reserve Bank is fully owned and operated by the Government of India. As
mentioned in the Preamble of the Reserve Bank of India, the basic functions of the
Reserve Bank are: NOTES
 To regulate the issue of Banknotes
 To secure monetary stability in India
 To modernise the monetary policy framework to meet economic challenges
The Reserve Bank’s operations are governed by a central board of directors,
RBI is on the whole operated with a 21-member central board of directors
appointed by the Government of India in accordance with the Reserve Bank of
India Act. The Central board of directors comprise of:
 Official Directors – The governor who is appointed/nominated for a
period of four years along with four Deputy Governors
 Non-Official Directors – Ten Directors from various fields and two
government Officials
Organizational structure
Fig. 8.1 Central Board of Directors

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Indian Banking 8.2.2 Major Functions of RBI
Let us discuss the major functions of RBI.
Monetary Authority
NOTES
 Formulating and implementing the national monetary policy.
 Maintaining price stability across all sectors while also keeping the objective
of growth.
Regulatory and Supervisory
 Set parameters for banks and financial operations within which banking
and financial systems function.
 Protect investors interest and provide economic and cost-effective banking
to the public.
Foreign Exchange Management
 Oversees the Foreign Exchange Management Act, 1999.
 Facilitate external trade and development of foreign exchange market in
India.
Currency Issuer
 Issues, exchanges or destroys currency and not fit for circulation.
 Provides the public adequately with currency notes and coins and in good
quality.
Developmental role
 Promotes and performs promotional functions to support national banking
and financial objectives.
Related Functions
 Provides banking solutions to the central and the state governments and
also acts as their banker.
 Chief Banker to all banks: maintains banking accounts of all scheduled banks.
State Bank of India (SBI) is an Indian multinational, public sector banking
and financial services company. It is a government-owned corporation
headquartered in Mumbai, Maharashtra. The company is ranked 216th on
the Fortune Global 500 list of the world’s biggest corporations as of 2017. It is
the largest bank in India with a 23% market share in assets, besides a share of
one-fourth of the total loan and deposits market.
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The bank descends from the Bank of Calcutta, founded in 1806, via Indian Banking
the Imperial Bank of India, making it the oldest commercial bank in the Indian
subcontinent. The Bank of Madras merged into the other two “presidency banks”
in British India, the Bank of Calcutta and the Bank of Bombay, to form the Imperial
Bank of India, which in turn became the State Bank of India in 1955. NOTES
The Government of India took control of the Imperial Bank of India in 1955,
with Reserve Bank of India (India’s central bank) taking a 60% stake, renaming it
the State Bank of India. In 2008, the government took over the stake held by the
Reserve Bank of India.
The functions and objectives of the commercial banks are different from the Co-
operative banks. In this article we are giving some notable difference between
these two types of banks.
1. Commercial banks operate with the approach of commercialization while
Co-operative banks woks on the principle of co-operation. That is why
state Co-operative banks get loans at least 2% cheaper from the Reserve
bank of India.
2. Commercial banks have been constituted by an act passed by the parliament
while Co-operative banks are constituted by different sates under various
acts related to Co-operative societies of various states.
3. Co-operative banks have three tier set up in India i.e. state Co-operative at
the apex level, central/district co-operative banks at the middle level and
primary co-operative banks at the lower level while commercial banks don’t
have any such tier system in India.
4. Every commercial bank has the authority to take loan directly from the
Reserve Bank of India while in Co-operative banks, only state Co-operative
banks can enjoy this facility.
5. Commercial banks can establish its branches in any district/state of the
country while on the other hand Co-operative banks can operate its activities
only within limited area. As district cooperative banks can perform banking
activities only within the boundary of the concerned district and Primary
Co-operative banks can operate only in concerned villages.
As in the case of money-lenders, there is absence of reliable statistics regarding
the position of indigenous bankers in different part of the country, their financial
resources and their scale of operations but it is recognised that amongst the agencies
financing agriculture and the internal trade and small industries the indigenous bankers
occupy a prominent position. The indigenous banker, in addition to making loans
like the money-lender, receives deposits or deals in bundles or performs both
these functions, unlike the money-lender. He has usually a larger working capital.
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Indian Banking Whereas both the indigenous banker and money-lender lend partly with and partly
without security, the former more often does with than without and the latter more
often without than with security. The clients of the indigenous banker repay punctually
and the rates of interest charged by the banker are lower than in the case of the
NOTES money-lender. The indigenous banker is particular about the objects of the loan
and runs lessor risk. The money-lender lends for heterogeneous purposes and
incurs a bigger risk. As between the indigenous banker and the urban money-
lender, the former finances trade and industry rather than consumption, the letter
finances consumption rather than trade. In general, these two broad groups shade-
into each other, the difference between them being often of degree rather than of
type.
Check Your Progress

1. What are the basic functions of the Reserve Bank?
2. Who does the Central board of directors of the Reserve Bank comprise
of?
8.3 NABARD
On the recommendations of the committee to review arrangements for Institutional

Credit for Agriculture and Rural Development, the National Bank for Agricultural
and Rural Development Act, 1981 was passed by the Parliament and the National
Bank for Agricultural and Rural Development (NABARD) was established in July
1982 with an initial capital of 100 crore. The capital has been subsequently
raised to 2,000 crore. NABARD started its operations in November 1982 by
taking over the developmental and refinancing functions of the ARDC on the one
hand and the RBI on the other. The Bank was organized with the basic objective
of establishing an apex institution in the field of agricultural and rural development
finance in such a way as to integrate the financing of various institutions involved in
the development of rural areas.
The paid-up capital of NABARD is shared equally by the Government of
India and the RBI. It can augment its resources by drawing funds from the Central
Government, the state governments, the RBI, international agencies including the
World Bank group and by raising funds from the market through bonds and
debentures. In addition, the resources of the National Agricultural (Long-term
Operations) and the National Agricultural (Stabilization) Funds of the RBI stand
transferred to the National Rural Credit (Long-term Operations) and the National
Rural Credit (Stabilization) Funds of the NABARD. It can also borrow from the
RBI for financing its short-term lending operations. In short, NABARD is well
equipped with adequate financial resources to meet its commitments in the field of
agricultural and rural development.
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The management of NABARD is vested in a Board of Directors, consisting Indian Banking
of the following members:

(a) A Deputy Governor of the RBI as Chairman.
(b) Three nominees of the RBI. NOTES
(c) Three nominees of the Central Government.
(d) Three members, two with experience in cooperative banking and one
in commercial banking.
(e) Two nominees of the state governments.
(f) Two experts in rural economics and rural development.
(g) A managing director.
(h) One or more full time directors.
Functions
NABARD is established as a development bank, in terms of the preamble of the
Act, ‘for providing and regulating credit and other facilities for the promotion and
development of agriculture, small-scale industries, cottage and village industries,
handicrafts and other allied economic activities in rural areas with a view to promoting
integrated rural development and securing prosperity of rural areas and for matters
connected therewith or incidental thereto’. As an apex institution, it is accredited
with all matters concerning policy, planning and operations in the field of credit for
agriculture and other economic activities in rural areas. It performs all the functions
performed by the erstwhile ARDC as well as those performed by the Agricultural
Credit Department of the RBI in the field of agricultural and rural credit. Briefly,
these include:
1. Provision of short-term, medium-term and long-term financial assistance to
cooperative credit institutions, RRBs and commercial banks for promoting
agricultural and rural development;
2. Provision of long-term loans to state governments for contribution to the
share capital of cooperative credit institutions;
3. Provision of long-term loans to any institution approved by the Central
Government
4. Contribution to the share capital of ordinary/rural debentures issued by any
institution involved in agricultural and rural development;
5. Provision of necessary resources by way of refinance to the institutions
providing investment and production credit for promoting the various
developmental activities in rural areas;
6. Participation in institution building for improving absorption capacity of the
credit delivery system including monitoring, formulation of rehabilitation
schemes, restructuring of credit institutions, training of personnel, etc.;
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Indian Banking 7. Coordination of the rural financing activities of all the institutions engaged in
developmental work at the field level and maintaining liaison with Government
of India, state governments, RBI and other national level institutions
concerned with policy formulation;
NOTES
8. Preparation, on an annual basis, rural credit plans for all districts in the
country (these plans form the basis for annual credit plans of all rural financial
institutions);
9. Undertaking monitoring and evaluation of projects refinanced by it;
10. Promotion of research in agricultural and rural development;
11. Inspection of cooperative credit institutions and RRBs.
It is gratifying to note that NABARD has played its dual role as an apex
institution and as a refinancing agency creditably by participating actively in the
development of policy formulation, planning, coordination, monitoring research,
training and consultancy as well as refinancing areas relating to agricultural and
rural development. The Research Cell of the Bank is paying particular attention to
ensure that weaker sections of the rural population benefit more by schemes of
refinance by the Bank, that there is simplification of procedures so that quick
disposal of applications is possible and that the government’s programmes of
poverty eradication are supported in a meaningful way.
Resources of NABARD
Since 31 December 2006, the RBI has stopped providing funds to NABARD
through general line of credit (GLC) limit and it was advised to consider accessing
the market on a regular basis. Accordingly, in 2006–07 NABARD raised resources
mainly by way of bonds and debentures, besides the RIDF deposits. During 2007–
08, NABARD had sizable amount of resources for lending activity due to the
substantial rise in the RIDF deposits and other liabilities such as corporate bonds,
Bhavishya Nirman bonds and NABARD rural bonds. Besides, NABARD was
also permitted to raise resources during 2007–08 through a new source, viz.,
certificate of deposits. Also, an amount of 400 crore was transferred to the
NRC (LTO) fund and 10 crore to NRC (stabilization) fund. The resources of
NABARD increased to 17,486 crore during 2007–08.
Cooperative Development Fund
An important development in the area of institutional strengthening programmes in
1992–93 was the setting up of a Cooperative Development Fund. The fund was
set up for providing assistance to cooperative credit institutions to improve their
functional efficiency. Under the scheme, financial assistance is provided to various
StCBs/SCARDBS/CCBs/PCARDBS for infrastructural development, building
up of a Management Information System (MIS), hiring of outside agencies for
conducting special studies/seminars, etc., and meeting the expenses in connection
with performance awards given to cooperative banks based on their performance.
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Rural Infrastructure Development Fund (RIDF) Indian Banking
RIDF was initially set up in NABARD in 1995–96 with a corpus of 2,000 crore
with the major objective of providing funds to state governments and state-owned
corporations at reasonable rates to enable them to complete various types of rural NOTES
infrastructure projects pertaining to irrigation, flood protection, rural roads, bridges,
etc. The fund was set up as a joint initiative by the Central Government and
NABARD in order to develop infrastructure in rural areas , particularly in the
backdrop of declining public investments in agriculture and rural sectors. Under
the scheme, the Central Government, through budgetary outlays, contributes to
the corpus fund of RIDF. Commercial banks can, in turn, deploy their shortfalls in
priority sector lending target to the fund. In order to encourage commercial banks
towards direct lending to agriculture/priority sector, interest rates earned by
commercial banks on RIDF deposits are kept inversely related to the shortfall in
lending to agriculture. Furthermore, for ensuring parity in risk weights assigned to
direct priority sector lending and RIDF deposits, credit risk weights for both types
of fund deployments by commercial banks have been fixed at 100 per cent.
The Fund has completed 16 years of operation by 2010–11. As at the end
of March 2011, the total amount of deposits collected under RIDF scheme stood
at 95,785 crore. A separate window, namely National Rural Roads Development
Agency (NRRDA) was introduced in 2006–07. NRRDA was introduced with
the objective of funding the rural roads component of Bharat Nirman Programme
introduced by the Central Government. As at end-March 2011, the aggregate
allocation of NRRDA stood at 18,500 crore.
Credit Extended by NABARD
NABARD provides short-term credit facilities to StCBs for financing seasonal
agricultural operations, marketing of crops, pisciculture activities, production/
procurement and marketing activities of industrial cooperatives, financing of
individual artisans through PACs, purchase and distribution of fertilizers and allied
activities and marketing activities. Medium-term facilities were provided to StCBs
and RRBs for converting short-term loans for financing seasonal agricultural
operations to medium-term (conversion) loans and approved agricultural purposes.
Long-term loans are provided to the state governments for contributing to share
capital of cooperative credit instituions. During 2007–08, NABARD sanctioned
total credit limits of 18,689 crore for various short and medium-term purposes
to StCBs and RRBs. The interest rate charged by NABARD has been uniform
irrespective of the size and purpose of the loan.
Kisan Credit Card Scheme
The Kisan Credit Card (KCC) scheme introduced in August 1998 aims at providing
adequate, timely and cost effective and hassle-free credit support to the farmers
and is being implemented across India by all public sector commercial banks,
RRBs and cooperative banks. The scheme is popular among both farmers and
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Indian Banking issuing bankers. Farmers have the flexibility to avail of production credit and also
avoid procedural delays in getting credit sanctioned. For bankers, the need for
repeated processing of credit applications is avoided. To cater to the comprehensive
credit requirements of farmers under a single window, the scope of KCC is
NOTES broadened by NABARD from time to time. In addition to short-term credit needs
and term loans for agriculture and allied activities, a certain component of loans
through KCC also covers consumption needs of the farmers, including defaulters,
oral lessees, tenant farmers and share croppers, among others, who might have
left out of the KCC scheme as also to identify new farmers. Banks were also
advised to issue KCCs in a hassle-free manner and extend crop loans only through
KCCs. To further expand the coverage of borrowers under KCC, the scheme
was extended to borrowers of long-term cooperative credit structure, viz.,
PCARDBs and SCARDBs. As at the end of March 2011, the total number of
KCCs issued stood at 104 million all over the country.
Gramin Tatkal Scheme
The Gramin Tatkal scheme formulated by NABARD is a unique loan product
combining investment, production and consumption needs of rural families. The
approach towards lending is ‘family-centric’ and the credit needs are assessed
and loan decisions and repayment potential are determined on the basis of family
cash flow, thus, allowing banks to decide the loan size and interest rate payable.
The scheme is being implemented from 2006–07.
Role of NABARD in Rural Credit
The role of NABARD in rural credit has been highlighted in the previous paragraphs.
This may be recapitulated briefly here : In the area of rural credit, NABARD is the
apex organization and as such it has been playing a very important role in enhancing
the credit flow to the rural economy since its inception in 1982. It is actively
involved in refinancing of rural lending institutions such as regional rural banks and
cooperative credit institutions as also in the recapitalisation of these institutions.
NABARD is also entrusted with the responsibility of supervision of rural cooperative
credit institutions. Special schemes to improve credit flow to the rural economy,
viz., Rural Infrastructure Development Fund and Kisan Credit Card are also
entrusted with NABARD.
Role of NABARD in Reviving Rural Co-operative Credit Institutions
The short-term credit provided by NABARD to cooperatives is mainly used for
financing seasonal agricultural activities, marketing of crops, and pisciculture
activities. The medium-credit is used for financing other approved agricultural
purposes and the long-term credit involves loans given to state governments. During
2010–11, the total credit disbursed by NABARD was significantly higher as
compared to the previous years.
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Revival of Short-term Structure Indian Banking
The approved revival package for rural cooperative credit institutions prepared
based on the Vaidyanathan Committee (Task Force on Revival of Rural
Cooperative Credit Institutions) Report is under implementation. Government of NOTES
India has entered into agreements with multilateral agencies such as World Bank,
Asian Development Bank and KFW (Kreditanstalt fur Wiederaufbau) for financial
assistance to implement the revival package at the State level. The National
Implementation and Monitoring Committee (NIMC) has been constituted for
guiding and monitoring the implantation of the package at national level. At State
level, the progress is being monitored by State level Implementing and Monitoring
Committees and at district level by DCCB Level Implementing and Monitoring
Committees. At NABARD level, review meetings of Regional Offices of
Implementing States are periodically held for the same.
Till the end of 2009–10, 25 state governments (except Goa, Himachal
Pradesh and Kerala) have signed the MOU with Government of India and
NABARD, which covers 96 per cent of short-term rural cooperative credit units
in the country. Further, an amount of 7,972 crore has been released by NABARD
as Government of India’s share for recapitalisation of 49,764 PACs in 14 states,
while state governments have released 756 crore as their share. The State Co-
operative Societies Acts have been amended in 21 states through legislative process.
For conducting the statutory audit of StCBs and DCCBs, NABARD
provided a panel of chartered accountants to 13 states. The audit process in rest
of the states is under different stages. Further, in order to bring qualified
professionals in the management of cooperatives, the Reserve Bank of India has
prescribed ‘fit and proper criteria’ for appointment of the directors and chief
executive officers (CEOs) of cooperatives. professional directors as well as CEOs
as per fit and proper criteria were put in place in many of the banks across states.
Elected Boards are in place in almost all units of STCCS in all states except
Andhra Pradesh, Arunachal Pradesh, Manipur, Nagaland and Tamil Nadu. The
Common Accounting System (CAS) was introduced from April 1, 2009 in almost
all PACs in 11 states. Guidelines on computerisation of CAS and Management
Information System (MIS) for PACs were issued in two separate modules, and it
is in progress in 3 states. As per decision of NIMC, it has been decided to develop
core software for PACs at the national level.
Training and Human Resource Initiative
A working group set up by NABARD designs training modules for training electoral
directors and staff of PACS. Till the end of 2010–11, training has been imparted
to 254 master trainers from 23 states. These master trainers have trained 2039
district level trainers to conduct field level training programmes for PACS. 81,037
PACS secretaries have been trained in 17 states and 12,354 elected members of
PACS have been trained in 14 states.
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Indian Banking A new programme on business development and profitability for PACS
secretaries has since been rolled out and 76 master trainers from 12 implementing
states were trained at Bankers Institute of Rural Development, Lucknow. Till the
end of 2010–11, 36,125 PACS staff in eight states have been trained. Also, a
NOTES five-day in-campus orientation programme for branch managers and senior officers
of CCBs/StCB for business development/diversification has been developed and
1,582 branch managers/senior officers of DCCBs, StCB have been trained.
Check Your Progress

3. What is the full form of NABARD?
4. Mention the aim of the Kisan Credit Card scheme introduced in 1998.

QUESTIONS
1. The Preamble of the Reserve Bank of India describes the basic functions of
the Reserve Bank are:
 Regulating the issue of Banknotes
 Securing monetary stability in India
 Modernising the monetary policy framework to meet economic
challenges
2. The Central board of directors of the Reserve Bank comprise of:
 Official Directors – The governor who is appointed/nominated for a
period of four years along with four Deputy Governors
 Non-Official Directors – Ten Directors from various fields and two
government Officia
3. The full form of NABARD is National Bank for Agricultural and Rural
Development.
4. The Kisan Credit Card (KCC) scheme introduced in August 1998 aims at
providing adequate, timely and cost effective and hassle-free credit support
to the farmers and is being implemented across India by all public sector
commercial banks, RRBs and cooperative banks.
8.5 SUMMARY
 The Reserve Bank is fully owned and operated by the Government of India.
 The Reserve Bank’s operations are governed by a central board of directors,
RBI is on the whole operated with a 21-member central board of directors
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appointed by the Government of India in accordance with the Reserve Bank Indian Banking
of India Act.
 State Bank of India (SBI) is an Indian multinational, public sector banking
and financial services company.
NOTES
 By far the most important constituent of the bazar money market is the
indigenous banker.
 On the recommendations of the committee to review arrangements for
Institutional Credit for Agriculture and Rural Development, the National
Bank for Agricultural and Rural Development (NABARD) was established
in July 1982.
 The paid-up capital of NABARD is shared equally by the Government of
India and the RBI.
 An important development in the area of institutional strengthening
programmes in 1992–93 was the setting up of a Cooperative Development
Fund.
 The Kisan Credit Card (KCC) scheme introduced in August 1998 aims at
providing adequate, timely and cost effective and hassle-free credit support
to the farmers and is being implemented across India by all public sector
commercial banks, RRBs and cooperative banks.
 The Gramin Tatkal scheme formulated by NABARD is a unique loan product
combining investment, production and consumption needs of rural families.
 The short-term credit provided by NABARD to cooperatives is mainly
used for financing seasonal agricultural activities, marketing of crops, and
pisciculture activities.
8.6 KEY WORDS
 Cooperatives: A cooperative is an autonomous association of persons

united voluntarily to meet their common economic, social, and cultural needs
and aspirations through a jointly-owned and democratically-controlled
enterprise.
 Commercial Banks: A commercial bank is an institution that provides
services such as accepting deposits, providing business loans, and offering
basic investment products.
 Loan: A loan is money, property or other material goods that is given to
another party in exchange for future repayment of the loan value amount.
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Indian Banking
EXERCISES

1. Write a short note on the management of the Reserve Bank of India.
2. What are indigenous banks?
3. What do you understand by NABARD?
4. What is Rural Infrastructure Development Fund (RIDF)?
5. How has NABARD played an influential role in rural credit?
1. Comment on the major functions of the Reserve Bank of India.
2. What are the major differences between commercial and cooperative banks?
3. Dicuss the management and functions of NABARD.
4. Discuss the major provisions of Kisan Credit Crad Scheme and Gramiin
Tatkal Scheme.

Delhi.
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State Bank of India
UNIT 9 STATE BANK OF INDIA

Structure NOTES
9.0 Introduction
9.1 Objectives
9.2 The State Bank of India: Objectives and Functions
9.2.2 Objectives
9.3 State Bank of India: Working and Progress
9.5 Summary
9.6 Key Words
9.0 INTRODUCTION
The State Bank of India is a regional banking behemoth and is one of the largest
financial institutions in the world. Among Indian commercial banks, its market
share in deposits and loans is around one-fifth. It is the largest Big Four banks in
India, the others being ICICI Bank, Punjab National Bank and HDFC Bank. In
July 2011, the State Bank of India agreed to grant a loan of 100 billion to National
Thermal Power Corporation (NTPC), making it the largest loan given to any single
customer in its entire history of two centuries.
9.1 OBJECTIVES

 Discuss the history of the State Bank of India
 Understand the management of the State Bank of India
 Describe the objectives and functions of the State Bank of India
 Describe the structure of the State Bank of India
9.2 THE STATE BANK OF INDIA: BRIEF

HISTORY
The State Bank of India, the oldest and the largest commercial bank in India, by
revenue, assets and market capitalisation with its presence covering all time zones
in the world, stands in a class by itself. As at end-March 2012, the assets of the
bank stood at US Dollars 360 billion and had more than 14,000 branches including
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State Bank of India 173 foreign offices spread over 34 countries, comprising of 50 branches, 8
representative offices, 103 offices of foreign banking subsidiaries and 12 other
offices, and agents globally. It has been ranked 285th in the Fortune Global
Under the Imperial Bank of India Act, 1920, the governing body of the bank
NOTES
was the central Board. Its functions were defined in the by-laws. There were also
local boards at the three Presidency Towns with fairly wide powers for managing
local business; but they were under the control of the Central Board. The Central
Board was comprised of the Presidents and Vice-Presidents of the Local Boards,
representing the shareholders, the Comptroller of Currency, representing the
Government of India, four Governors nominated by the government to serve
representation of the interests of the Indian community in general, the secretaries of
the Local Boards, and two Managing Governors appointed by the Government of
India, on the recommendations of the Central Board, holding office for such periods
as the government directed from time to time.
Until the establishment of the Reserve Bank of India in 1935, the Imperial
Bank had in effect been discharging certain central banking functions. Briefly stated,
the main central banking functions that the bank was discharging were:
1. Acting as a sole banker to the government and as the custodian of public
funds and government cash balances, central and local, and also the
balances of the Secretary of State through its London Office.
2. Undertaking the functions arising from the issue of new loans by the
government and managing the public debt in return for a specified
remuneration.
3. Giving the public facilities for the transfer of money between its branches
at rates approved by the Comptroller of Currency.
In addition to the above central banking functions (the Act, of course, did
not give power to the bank to issue notes), the bank performed the ordinary
commercial banking business. But, because of the special nature of the bank,
certain restrictions were imposed by the government on its ordinary commercial
banking functions. According to these restrictions, the bank was prohibited from
making loans to a longer period than six months or on the basis of immovable
properties or on the security of its own shares or stocks; from discounting or
making loans against any bill of exchange unless it carried the several responsibilities
of at least two persons or firms unconnected with each other in general partnership,
and from granting unsecured overdraft in excess of 1 lakh. The bank was
statutorily debarred from dealing in foreign exchange except to meet the bonafide
needs of its own clients.
With the establishment of the Reserve Bank of India in 1935, the Imperial
Bank ceased to be the banker to the government directly. Further, the Imperial
Bank of India (Amendment) Act, 1934, removed all the restrictions which were
formerly imposed on its lending operations. Under the Act, the bank could transact
foreign exchange business and undertake banking business of any kind.
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Although the Imperial Bank ceased to be the banker to the government State Bank of India
directly with the establishment of the Reserve Bank, it was authorized to act as the
sole agent of the Reserve Bank in places where the latter did not have its own
branches. Accordingly, the Imperial Bank was permitted on behalf of the
government to pay, receive, collect and remit money, bullion and securities as the NOTES
agent of the Reserve Bank, and to undertake and transact any other business
which the Reserve Bank may from time to time entrust to the bank. Thus, the
Imperial Bank stood in a special category and it was the leader of the Indian
money market.
Nationalization of the Imperial Bank
When the question of nationalization of the Imperial Bank of India came up first in
February 1948, the government accepted the principle of nationalization. But this
was opposed by the Central Board of Directors and shareholders. They put forward
many arguments against nationalization, and ultimately, the government announced
in 1949 the indefinite postponement of the question of nationalization of the Imperial
Bank. But the question came up again when the All India Rural Credit Survey
Committee recommended the creation of a State Bank of India by amalgamation
of certain state-owned banks with the Imperial Bank. Accordingly, the State Bank
of India Act was passed in May 1955, and the State Bank of India came into
existence on 1 July 1955.
The State Bank of India (SBI) was established by the statutory amalgamation
of the Imperial Bank of India and certain major state associated banks. The branches
of these state associated banks along with the branches of the Imperial Bank of
India would have a larger coverage of several areas and also greater scope for
much larger future extension to rural areas. That is why the Rural Banking Enquiry
Committee stated in its report that ‘if these banks could be integrated into one
institution, and if that one institution could be aligned to national policies, then
indeed that would be an extremely important and extremely desirable line of
development’. Thus, the nationalization of the Imperial Bank and the establishment
of the State Bank of India was an important milestone on the road to the
establishment of an integrated commercial banking unit with branches all over the
country under effective state control.
Originally, the State Bank of India was established with an authorized share capital
of 20 crore and an issued share capital of 5.625 crore which was allotted to the
Reserve Bank of India. In order to enhance the capital adequacy ratio, the
authorized capital of the SBI was raised from 20 crore to 200 crore in 1985.
Its subscribed and paid-up capital was raised to 50 crore, while those of the
associate banks were raised to 10 crore each. Again, an ordinance was issued in
1993 leading to an amendment of the SBI Act, 1955 to enable SBI to raise money
from the market. Accordingly, SBI entered into the capital market successfully.
With this, the issued and paid-up capital of the bank reached 456 crore. Self-Instructional
Material 151
State Bank of India Management of the SBI is vested with a Central Board which consists of:
1. A Chairman and a Vice-Chairman to be appointed by the Central
Government in consultation with the Reserve Bank and after
consideration, except in case of first appointments, of the
NOTES
recommendations made by the Central Board.
2. Not more than two Managing Directors, appointed by the Central Board,
with the approval of the Central Government.
3. Six directors to be elected by the shareholders other than the Reserve
Bank of India whose names are entered in the various branch registers.
4. Eight directors to be nominated by the Central Government in consultation
with the Reserve Bank to represent territorial and economic interests in
such a manner that not less than two of them have special knowledge in
the working of the co-operative institutions and of rural economy and
the others have experience in commerce, industry, banking or finance.
5. One director to be nominated by the Central Government.
6. One director to be nominated by the Reserve Bank.
The Chairman and the Vice-Chairman shall hold office for such term, not
exceeding five years, as the Central Government may fix. The Managing Director
shall hold office for such term, not exceeding five years, as the Central Board or,
in the case of the first two appointments, the Central Government may fix.
Besides the Central Board, there are local boards at Mumbai, Kolkata,
Chennai and New Delhi.
Some time back, SBI restructured its organizational structure to bring about
decision-making. The top management team now comprises the Chairman, group
executives for the national banking group, corporate banking group, international
banking and associates and subsidiary banks. In addition, four staff functionaries
have been appointed in charge of financial management, credit, human resources
and technology management, and inspection and audit.
9.2.2 Objectives
The main objective in nationalizing the Imperial Bank of India has been the setting up
of a strong State-partnered commercial banking institution with an effective machinery
composed of a large network of branches over the whole country. It was made
clear by the then Union Minister of Finance that the nationalization of the Imperial
Bank was not based on ideological grounds. But it was intended to acquire control
over a strategic section of commercial banking with a view to developing credit
facilities for areas of the national economy not well served in this respect.
Further, the activities of the SBI are expected to be in conformity with the
broad economic policies pursued by the government. This will have an effect on
the activities of other commercial banks since the SBI commands nearly one-third
of the entire commercial bank resources.
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Another important objective for which the Bank has been established is to State Bank of India
promote agricultural finance and to remedy the defects in the system of agricultural
finance. The role played by the Bank in this field is discussed in detail subsequently.
Moreover, the SBI is expected to be of service to the Reserve Bank in its
NOTES
monetary policies and to check any disequilibrium that is likely to develop in the
money market.
For the first phase of the branch expansion programme, the SBI Act had
provided for the opening of not less than 400 branches within a period of five
years beginning from 1 July 1955. This statutory obligation was successfully fulfilled
within the specified time limit. In fact, the Bank had opened 416 branches by the
end of June 1960. A noteworthy feature of the branch expansion programme was
that the number of new branches opened by the Bank at the sub-treasury centres
worked out about one branch for every three non-banking centres as against one
branch for every five recommended.
The Bank had opened its 5000th branch in early 1979. As at the end of
March 2012, the Bank had more than 14,000 branches including 173 foreign
offices spread over 34 countries.
Simultaneously, the Bank is giving attention to the necessity of extending
banking facilities to the rural areas. The attention given by the Bank over the years
in extending banking facilities in rural and semi-urban areas is reflected in the
proportion of such offices to the total number of offices.
SBI is the only Indian bank that figures in Fortune top 100 banks. With
nearly 11,000 branches and 5,600 ATMs, it has a reach throughout the length and
breadth of the country; it has a work force of nearly 200,000. It is the second
largest bank in the world measured by the number of branches and employee
strength. It had total assets of 5,66,565 crore and posted a net profit of 4,541
crore as on 31 March 2007.
SBI offers the services of banking as well as whole array of financial services
which include mutual funds, credit cards, life insurance, merchant banking, security
trading and primary dealership in the money market. The bank is actively involved
in non-profit activity termed community services banking apart from its normal
banking activity.
Information Technology
The Bank has adopted and is pursuing vigorously its information technology (IT)
policy with the aim of achieving efficiency in operations, meeting customer and
market expectations and staying ahead in competition, especially in the context of
the emergence of the new generation private sector banks equipped with state-of-
the-art technology.
In December 2000, the Bank has introduced Electronic Nostro Account
Reconciliation (ELENOR). This helps fast, accurate and fully integrated reporting
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State Bank of India of foreign exchange transaction and has made a major breakthrough in effectively
tackling NOSTRO reconciliation. It has enabled online reporting of forex
transactions from 444 forex intensive branches. In January 2001, State Bank
Electronic Payment Systems (STEPS) became operational. This facilitates
NOTES instantaneous electronic transfer of funds in 1,557 branches. At the end of March
2002, tele-banking has been implemented at 106 branches where customers can
access their accounts through telephone from anywhere at any time. As at that
date, the number of fully computerized branches of the Bank stood at 3,035,
covering 80 per cent of the Bank’s domestic business. The computerized branches
have brought improvement in customer service, introduced features such as network
ATMs, internet banking, tele-banking and customer enquiry terminals.
State Bank Group has variants of ATMs ‘namely’ Bunch Note Acceptors,
Biometric ATMs, low-cost rural ATMs, solar-powered ATMs, multi-function
kiosks-for printing passbooks, statement of accounts, bar code readers for utility
bill payments, internet banking etc. Cash deposit facility has been activated at
some of the ATMs and the Bank is in the process of deploying a large number of
cash deposit machines (bunch note acceptors) at ATM locations which customers
can use 24 × 7 to deposit cash. Cash out incidents in ATMs have been eliminated.
As on 31st March 2012, there were 3.65 Million customers using mobile
banking service with more than 1.20 lacs daily transactions, around 46 per cent of
which are financial transactions amounting to 2.45 crores. SBI is the market
leader in this space, both in the number and value of the financial transactions with
83.70 per cent market share in number of transactions and 49 per cent share in
transaction value. State Bank Freedom Premium, the new GPRS based mobile
banking service has been rolled out. SBI has launched mobile technology based
prepaid payment services under the brand name of State Bank MobiCash on
pilot basis in Delhi and Mumbai Circles of the bank.
Internet banking service is available for both retail and corporate customers
of the bank. Retail Internet Banking: SBI ‘Instapay’ for utility billspayment,
Corporate Internet Banking: CINB Saral—a simplified single user Corporate
Internet Banking facility for small entrepreneurs etc., have been added during
2011–12.
Bank offers Real Time Gross Settlement System (RTGS) & National
Electronic Fund Transfer system (NEFT) which enables an efficient, secure,
economical and reliable system of transfer of funds from bank to bank as well as
from remitter’s account in a particular bank to the beneficiary’s account in another
bank across the country.
RTGS is an electronic payment system in which payment instructions between
banks are processed and settled individually and continuously, on a real time basis,
throughout the day NEFT is another electronic payment system in which payment
instructions between banks are processed and settled on deferred net settlement
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(DNS) basis at fixed times during the day. There is no minimum or maximum State Bank of India
stipulated transaction value for using this facility.

State Bank MobiCash is a pre-paid wallet on Mobile phone. It is usable
anytime, anywhere. It offers facilities like money transfer, cash payments, mobile
NOTES
top ups, etc. The services are available beyond regular banking hours. Its features
include cash deposit, cash withdrawal, fund transfer from wallet to wallet, fund
transfer from wallet to SBI account, fund transfer from wallet to another bank
account, mobile / utility bill payments, and recharge of prepaid mobile / DTH /
broadband.
Risk Management
In view of the critical importance given to risk management under the present day
circumstances, the Bank’s risk management policies are based on the premise that
the management of risks can be segregated by types, and the risks can be better
comprehended by units most capable of understanding them.
Central Board of the Bank is primarily responsible for management of risks.
The Central Board approves the risk management policies and structure of risk
management. Credit Policy and Procedures Committee/Chief Credit Officer is
responsible for the management of credit risks relating to domestic loans. Assets
and Liability Management Committee/Chief Financial Officer is responsible for
the management of market risks. The forex risks and international exposure are
looked after by the Group Executive, International Banking. The Bank has
constituted an Integrated Risk Management Committee at the apex level in order
to examine and decide upon the issues relating to integrated risk management.
The Risk Governance Structure in place in the Bank is as under:
In relation to Integrated Risk Management covering Enterprise, Credit,
Market, Operational and Group Risks, a Risk Governance structure is operating.
This framework visualises empowerment of Business Units at the operating level,
with technology being the key driver, enabling identification and management of
risk at the place of origination.
Basel Implementation
 The Bank has migrated to the Basel II framework in step with the guidelines
of the Reserve Bank of India Guidelines, with the Standardised Approach
for Credit Risk and Basic Indicator approach for Operational Risk with
effect from 2008, having already implemented the Standardised
Measurement Method for Market Risk with effect from 2006.
 RBI has issued Guidelines on Implementation of Basel III Capital Regulations
in India in May, 2012. These Guidelines will become effective from January
1, 2013. Bank is in the process of putting in place appropriate mechanism
to comply with these guidelines.
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State Bank of India Enterprise Risk Management
 During 2011–12, the Bank has set in motion the due process required for
filing of application/letter of intent to RBI for implementing Advanced
NOTES Approaches under Basel II, comprising of the three Pillar I Risks viz. Internal
Rating Based (IRB) approach for Credit Risk, Internal Model Approach
for Market Risk and Advanced Measurement Approach for Operational
Risk.
 The Bank has in place the Internal Capital Adequacy Assessment Process
(ICAAP)Document as required by Pillar II of New Capital Adequacy
Framework under Basel II in accordance with the Guidelines of the Reserve
Bank of India.
 The ICAAP process covers identification, measurement, management,
capital assessment and stress testing of material risks and also detailed
additional capital requirements on account of such risks. In addition to the
aforesaid three Pillar I Risks, the ICAAP also covers Pillar II Risks such as
Liquidity Risk, Interest Rate Risk in the Banking Book, Credit Concentration
Risk, Reputation Risk, Strategic Risk, etc.
Credit Risk Management (CRM)
 Besides implementing the Standarised Approach, well defined credit risk
practices such as use of Credit Risk Assessment (CRA) Models, Industry
Exposure Norms, Counterparty Exposure Limits, Substantial Exposure
Norms, Macro Economic Stress Tests etc., have also been put in place to
improve credit risk management.
 The Bank has set in process a project to migrate to Internal Rating
Based(IRB) Approach.
 Models for estimation of Probability of Default (PD), Loss Given Default
(LGD),and Exposure At Default (EAD) are being developed.
 Credit risk data mart is being set up.
 Retail scoring and behavioural scoring models are being implemented.
Market Risk Management (MRM)
As contained in the Reserve Bank of India Guidelines Market Risk Management
is governed by the Board approved policies covering Investment, Trading, Foreign
Exchange, Derivatives, Value at Risk & Stress Testing which stipulate limits for
various products and risk types in the portfolio. These limits along with Management
Action Triggers & Stop Loss Triggers are monitored on a daily basis and in case
of breaches; appropriate actions are initiated by the business units as per the
policy prescriptions.
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Operational Risk Management (ORM) State Bank of India
 Continuous review of systems and control mechanisms, creating awareness

of operational risk throughout the Bank, assigning risk ownership, alignment
of risk management activities with business strategy and ensuring compliance NOTES
with regulatory requirements are the chief objectives of the Bank’s ORM .
 The Operational Risk Management Policy of the Bank establishes a
consistent framework for systematic and proactive identification, assessment,
measurement, monitoring and mitigation of operational risk & applies to all
business and functional areas within the Bank, and is supplemented by
operational systems, procedures and guidelines which are updated.at
periodical intervals.
Group Risk Management (GRM)
 A Group Risk Management policy is in operation which applies to all
Associate Banks, Banking and Non-banking Subsidiaries and Joint Ventures
of the State Bank Group under the jurisdiction of specified regulators and
complying with the relevant Accounting Standards, where SBI has investment
in equity shares of 30 per cent and more with control over management of
the entity.
 All Group entities are encouraged to align their policies and practices with
the Group, follow Basel prescriptions, guidelines of their regulators besides
international best practices.
 The Group ICAAP Document for the State Bank Group is also prepared
and submitted to the Reserve Bank of India as required by Pillar II of New
Capital Adequacy Framework.
 Chief Information Security Officer [CISO]
A robust IT policy and Information System Security policy has been
implemented by the Bank. These policies are reviewed at periodical intervals and
suitably strengthened with a view to addressing emerging threats. Regular security
drills and employee awareness programs are conducted in order to ensure security
and increase awareness among staff. Bank is among the forerunners in the process
of implementing the new Reserve Bank of India Guidelines for the Banking Sector
in this area.
Internal Controls
The Bank has in-built internal control systems with well-defined responsibilities at
each level and conducts internal audit through its Inspection & Management Audit
Department. Supervision and control over the functioning of the department are
done by the Audit Committee of the Board(ACB) . The inspection system plays
an important and critical role in identification, control and management of risks by
using international best practices in the internal audit function which is regarded as
one of the most important components of Corporate Governance. Mainly two Self-Instructional
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State Bank of India streams of audits—Risk Focussed Internal Audit (RFIA) and Management Audit
covering different facets of Internal Audit requirement are carried out by the Bank.
All accounting units of the Bank like branches, Business Process Reengineering
(BPR) entities, major critical corporate centre departments like Foreign Account
NOTES Office, Treasury operations, Central Accounts Office etc., are subjected to RFIA.
Management Audit covers administrative offices and examines policies and
procedures in addition to quality of execution thereof.
Additionally, the department conducts Credit Audit, Concurrent Audit,
Information Systems Audit, Home Office Audit (audit of foreign offices) and
Expenditure Audit. Risk Focussed Internal Audit (RFIA) helps in appropriately
capturing all types of risks residing in operating units. Credit Audit is conducted
for units with large credit limits and Concurrent Audit is carried out at branches
including BPR outfits having large deposits, advances & other risk exposures.
Expenditure Audit is conducted at administrative offices including Corporate Centre
Establishments and Lead Bank Offices, etc. With a view to verifying the level of
rectification of irregularities by branches, audit of compliance at select branches is
also undertaken. The Information System Audit (IS Audit) of the centralised IT
establishments is also conducted.
Vigilance
The concept of Vigilance as an investigative process and an exercise for punitive
action has evolved to that of ‘Vigilance for Corporate Growth’, the emphasis
getting shifted from punitive vigilance to “Preventive and Proactive Vigilance”
through an active participation of all concerned.
In this context, two important issues deserve a special mention viz. (i)
Preventive Vigilance Committee (PVC) Meetings being held at the branches and
the BPR outfits and (ii)Whistle Blower Scheme. Through PVC meetings give a
chance to every employee to share his/her views on preventive vigilance, suggest
and implement various measures specifically suited to his/her workplace and
participate in a collective exercise of ensuring watchfulness and alertness in his/her
official functions. Under ‘Whistle Blower Scheme’ the staff members are expected
to advise appropriate authorities about irregular and unethical practices, if any,
being indulged in by colleagues and even seniors.
While Vigilance Administration seeks, as one of its functions, to suitably
punish the delinquent employees, it also protects the legitimate and bona fide
decisions taken in the interest of the organization. The number of vigilance case
brought to conclusion during the year 2011–12 is 1447, in which 1307 employees
have been inflicted with various penalties for their proven misconducts.
Non-performing Assets (NPAs) Management
Management of NPAs receives focused attention at all levels. At the corporate
level a Task Force consisting of top executives monitors all NPAs above 5 crore.
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At the local Head Office level, the Circle Management Committee monitors all State Bank of India
NPAs above 1 crore. The NPA management policy lays stress, among other
things, on early identification of problem loans, effective response to early warning
signals and appropriate recovery strategy including one-time settlement. Other
measures taken by the Bank include upgradation of appraisal skills of the officers NOTES
dealing in credit through special training programmes and an effective audit
mechanism, which throws warning signals for taking action to prevent performing
assets turning into non-performing ones.
9.3 STATE BANK OF INDIA: WORKING AND

PROGRESS
SBI had disbursed 1,32,300 crore under priority sector till March 2008.
Small-scale Industries
State Bank Group has been the most single source of institutional credit to small-
scale industries (SSIs) in the country. The assistance rendered by the Group to the
small-scale sector has been characterized as being need based, comprehensive
and liberal. The Group gives importance to the capacity, industry and integrity of
the small man. The assessment of the credit needs is done in a scientific manner,
aimed at covering the entire range of working capital advances as also the
requirements covering the acquisition of fixed assets.
In tune with the priorities laid down by the Reserve Bank of India, the
approach of the State Bank of India in particular in the field of small-scale industries
is selective. Units producing goods for export, mass consumption goods, capital
goods and inputs for the core sector and those situated in backward areas are
given preferential treatment. The Bank’s policy also aims at stimulating investment
in these selected industries by providing increasing quantum of term loans. The
approach towards the larger among the small-scale units is one of emphasis on a
greater degree of financial discipline, improvement in operational efficiency and
strengthening of managerial competence.
Following are given brief outlines of the various schemes formulated by the
Bank in the field of small-scale industries sector.
General Purpose Term Loans
Introduced in 2001–02, SBI grants term loans to small scale industrial units for
meeting general commercial purposes like substitution of high cost debt, research
and development, shoring up networth and funding business expansion. The tenure
of the loan is normally three years, and the pricing is fine-tuned to suit the risk
profile of the borrower. The SSI unit that takes the loan should not have history of
any defaults in payment of interest or instalments of the principal.
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State Bank of India Equity Fund Scheme
Under the scheme, the Bank grants financial assistance to entrepreneurs who are
not able to meet their share of equity fully, by way of interest-free loans repayable
NOTES over a long period. Equity Fund assistance is extended only to new projects,
which are also eligible for the Bank’s Liberalized scheme and the Entrepreneur
scheme. The project cost should be more than 25,000.
Liberalized Credit for SSIs
Production-linked credit facilities to SSIs, ancillary industrial units and village and
cottage industrial units are granted on liberal terms and conditions. Under this
scheme, the quantum of advances is not linked to the security furnished, but the
genuine requirements of the unit. The scheme offers a range of financial products
including—
(a) term loans for acquisition of fixed assets;
(b) working capital loans for financing current assets;
(c) letter of credit for acquisition of machinery and purchase of raw materials;
(d) bank guarantee in lieu of security deposits to be made with government
departments/other departments for execution of orders;
(e) deferred payment guarantees for purchase of machinery on deferred payment
basis;
(f) bill facility for purchase of raw materials and for sale of finished goods;
(g) composite loans (term loans plus working capital) up to 25 lakh.
Entrepreneur Scheme
Under this scheme, financial assistance is provided to technically qualified, trained
and experienced entrepreneurs for setting up new viable industrial projects.
Advances are granted to technocrats who are unable to meet the normal margin
requirements under the Liberalized schemes. The Bank provides term loans,
working capital finance and equity fund finance. For requirements up to 5 lakh,
no margins are involved. Beyond that, the margin is set at 10 per cent.
Stree Shakti Package
This package is aimed at supporting entrepreneurship among women by providing
certain concessions. For availing facilities under this package, the enterprise should
have more than 50 per cent of its share capital owned by women. The concessions
offered are:
(a) the margin will be lowered by 5 per cent as applicable to separate categories;
(b) the interest rate will be lowered by 0.5 per cent in case the loan exceeds 2
lakh; and
(c) no security is required for loans up to 5 lakh in case of tiny sector units.
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SME Credit Plus State Bank of India
Introduced in 2001–02, SME Credit Plus provides an additional credit limit to

existing borrowers who have a proven track record and it is structured to help
them meet unforeseen expenditure. The additional credit limit is capped at 20 per NOTES
cent of the fund-based working capital limit of the borrower, or a maximum of 25
lakh and is repayable in two months.
Export Credit
Pre-shipment Export Credit

SBI offers pre-shipment credit (packing credit) to the exporters, for financing
purchase, processing, manufacturing or packing of goods prior to shipments. This
means loans and advances extended on the basis of:
(i) letter of credit opened in favour of the client or in favour of some other
person, by an overseas buyer;
(ii) a confirmed and irrevocable order for the export of goods from India;
(iii) any other evidence of an order or export from India having been placed on
the exporter or some other person, unless lodgement of export order or
letter of credit with the bank has been waived.
Packing credit is granted for a period depending upon the circumstances of
the individual case, such as the time required for procuring, manufacturing or
processing (where necessary) and shipping the relative goods. Packing credit is
released in one lump sum or in stages, as per the requirement for executing the
orders. The pre-shipment/packing credit granted has to be liquidated out of the
proceeds of the bill drawn for the exported items, once the bill is purchased/
discounted, thereby converting pre-shipment credit into post-shipment credit.
Post-shipment Export Credit
The Bank extends post-shipment credit that is any loan/advance granted or any
other credit provided by the Bank for purposes such as export of goods from
India. It runs from the date of extending credit, after shipment of goods to the date
of realization of export proceeds and includes any loan/advance granted on the
security of any duty drawback allowed by the government from time to time. This
credit should be liquidated by the proceeds of export bills received from abroad in
respect of goods exported.
The following options are available to the exporter at post-shipment stage,
viz.,
(i) to get export bills purchased/discounted/negotiated;
(ii) to get advances against bills for collection and
(iii) to receive advances against duty drawback receivable from the
government.
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State Bank of India The exporter has the option to avail of pre-shipment and post-shipment
credit either in rupee or in foreign currency. However, if the pre-shipment credit
has been availed in foreign currency, the post-shipment credit has necessarily to
be under EBR scheme since foreign currency pre-shipment credit has to be
NOTES liquidated in foreign currency.
The Bank’s role in the field of export promotion is not confined to export
financing alone; but also extends to exploring and developing new markets for
Indian exports, both traditional and non-traditional. The Bank maintains an
information service for its customers on export possibilities for various commodities.
The Bank receives numerous requests from foreign banks for furnishing them with
names of Indian exporters of specific commodities. Such enquiries are widely
circulated through the medium of the Bank’s own offices as also through Chambers
of Commerce and other similar organizations at different centres.
One impediment to better export performance is the ignorance of Indian
exporters, particularly small exporters, in regard to export procedures and market
opportunities abroad. To bridge this information gap, the Bank has the International
Division in Mumbai. The Division seeks to bring together Indian exporters and
foreign importers, besides collecting and disseminating a wide range of information
and providing expert advice to exporters on trading conditions abroad.
The Bank is an active participant in the area of financing of project exports
involving execution of turnkey/civil construction contracts and export of engineering
goods on deferred payment terms. Some of the important activities supported
include overseas construction, railway and telecom related projects and power
projects.
Agricultural Banking
The Bank caters to the needs of agriculturists and landless agricultural labourers
through a network of 6,600 rural and semi-urban branches. There are 972
specialized branches set up in different parts of the country exclusively for the
development of agriculture through credit deployment. These branches include
Agricultural Development Branches, branches with Agricultural Banking Divisions
and Agricultural Business Branches. These branches cover a whole gamut of
agricultural activities like crop production, horticulture, plantation crops, farm
mechanization, land development and reclamation, digging of wells, tube wells
and irrigation projects, forestry, construction of cold storages and godowns,
processing of agri-products, finance to agri-input dealers, allied activities like dairy,
fisheries, poultry, sheep-goat, piggery and rearing of silk worms. Specialized
branches are provided with technical staff who provide technical guidance and
counselling to the farmers on their problems relating to farming activities. They
also hold farmers’ meet in villages to explain farmers about packages of practices
of crops before the onset of every crop season.
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The various schemes tailored to meet the needs of agriculturists are briefly State Bank of India
given below:
Crop Loans
Crop loans are extended to cultivators in the form of short-term direct finance. NOTES
Agriculturists, tenant farmers and share croppers who actually cultivate the lands
are eligible for crop loans.
Produce Marketing Loans
In order to avoid distress sale, assistance is provided to the farmers to stock the
produce on their own.
Agricultural Term Loans
These are provided in the form of direct finance to cultivators to create assets
facilitating crop production/income generation for periods ranging from 3 and 15
years. Activities broadly covered are land development, minor irrigation, farm
mechanization, plantation and horticulture, dairying, poultry, sericulture, dry land,
waste land development schemes, etc.
Minor Irrigation Schemes
Loans under these schemes cover activities like digging of new wells, deepening
of existing wells, laying of pipelines, installing drip/sprinkler irrigation system and
lift irrigation system. Repayment is spread over 5–15 years, depending on the
farm income.
Farm Mechanization Schemes
The Bank provides credit for purchase of farm equipments and machinery for
agricultural operations. This mode of finance covers activities such as purchase of
tractors, trailers, cultivators, cage wheels, power trillers, combine harvestors, etc.
Kisan Credit Card
The Bank offers kisan credit card for farmers under short-term credit introduced
as per RBI/NABARD guidelines, providing a running account facility to farmers
to meet their production credit needs and contingency needs. This scheme follows
simplified procedures to enable the borrowers to avail the crop loan.
Farmers with excellent repayment record for at least past five years are
eligible for the product. The scheme is intended to provide investment credit for
which term loans are ordinarily sanctioned. The scheme also includes major family
expenditure like marriage and education of children. Loan amount is fixed on the
basis of five times annual farm income or 50 per cent of the value of the land
mortgaged as collateral security, whichever is less, subject to a maximum of 5
lakh. Since its introduction in 1998–99, the scheme has become increasingly
popular.
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State Bank of India Micro-credit: Self-help Groups (SHGs)
Self-help groups are self-managed homogenous groups of economically backward
people that promote savings among themselves and pool the savings. These pooled
NOTES resources are supplemented by external resources, i.e., bank credit when these
groups gain experience. Since 1992, the Bank has been implementing the SHG
Linkage Programme. As at March-end 2006, SBI’s branches had opened 6,36,067
savings bank accounts of SHGs out of which more than 5.41 lakh SHGs had
been provided with credit facilities, thus benefiting more than 75 lakh poor people.
Majority of these SHGs are women SHGs.
State Bank Group
The State Bank of India is the founder and the flagship member of the State Bank
Group which is a giant commercial and investment banking group that dominates
the Indian banking scene with its seven commercial banking associates and several
subsidiaries and joint ventures, both foreign and domestic. With 18,324 branches
as in 2012, the SBI Group has the largest branch network in India. It is the only
Indian bank to set up a subsidiary incorporated in Europe, namely, the SBI European
Bank Ltd, at London. The six associate Banks of SBI are:
(i) State Bank of Bikaner & Jaipur;
(ii) State Bank of Hyderabad;
(iii) State Bank of Indore;
(iv) State Bank of Mysore;
(v) State Bank of Patiala;
(vi) State Bank of Travancore.
Proposals are there to merge all the associate banks with the State Bank of
India to create a ‘mega bank’ and stream line operations. The first step towards
unification was taken in 2008 when State Bank of Saurashtra was merged with
SBI. In 2009, the Board of Directors approved the merger of Bank of Indore.
The process of merger was completed in 2010 with SBI holding 98.3 per cent in
State Bank of Indore and government holding the balance of 1.77 per cent.
The Bank’s domestic subsidiaries/joint ventures include the following:
Banking Subsidiary
SBI Commercial and International Bank Ltd (SBICI)

The Bank holds 100 per cent equity in SBICI, amounting to 100 crore. As per
Notification issued by Government of India, the acquisition of SBI Commercial
and International Bank Ltd. (SBICI) by state Bank of India (SBI) has become
effective from 29 July 2011. All branches/offices of SBICI are now functioning as
branches of State Bank of India.
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Non-banking Subsidiaries/Joint Ventures State Bank of India
SBI Capital Markets (SBICAP)

SBICAP undertakes merchant banking services. It is engaged in an array of financial NOTES
services including advisory services for PSU disinvestments, infrastructure advisory
and syndication, private placement of debt, buy-back of shares and securitization
of receivables. SBI holds equity of 50 crore in SBICAP, being 86 per cent of its
share capital.
SBI Securities Ltd, (SBISL)
SBISL was set up as the broking arm of the SBI and had, accordingly, acquired
membership of the Stock Exchange, Mumbai and National Stock Exchange of
India Ltd. However, pursuant to a change in policy, the membership of both the
stock exchanges was transferred to SBICAP in March 2001.
SBI Factors and Commercial Services Ltd, (SBI FACTORS)
SBI FACTORS provides book debt financing. During 2001–02, it introduced
product variants like non-recourse factoring, purchase bill factoring and factoring
of usance bills backed by letter of credit/bank guarantee. SBI holds equity of
13.50 crore in SBI FACTORS, being 54 per cent of the latter’s share capital.
SBI Gilts Ltd, (SBIGL)
This is a primary dealer in the debt market, undertaking trading in government and
non-government securities. SBI holds equity of 61 crore in SBIGL, being 61 per
cent of the latter’s share capital.
SBI Funds Management Ltd, (SBIFML)
This is an Asset Management company set up for managing the affairs of SBI
Mutual Fund.
SBI Cards and Payments Services Ltd, (SBICPSL)
This is a credit card subsidiary and handles work relating to marketing, distribution,
risk management accounting and merchant acquiring. GE Capital is a partner in
this. GE Capital is the world’s largest private label card processor, managing over
80 million cards for over 300 clients in 20 countries.
SBICPSL which commenced operations in 1998–99, had nine lakh active
cards at March-end 2002. It is the third largest credit card issuer in the country.
The card has a market share of 15.25 per cent, and it is issued from 41 centres.
Credit Information Bureau (India) Ltd, (CIBIL)
In January 2001, SBI,HDFC, Dun & Bradstreet Information Services India Pvt.
Ltd, and Trans Union International Inc signed the shareholders’ agreement to
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State Bank of India establish the Credit Information Bureau (India) Ltd SBI and HDFC have 40 per
cent shareholding each and the other two companies have 10 per cent shares
each in CIBIL. The role of CIBIL is to:
(a) gather credit related information regarding individual and corporate/
NOTES
commercial credit users;
(b) maintain a database of this information and sell this information in the
form of credit reports to a closed user group for a price.
The potential users of CIBIL are banks, financial institutions, non-banking
financial companies, housing finance and credit card companies.
SBI Life Insurance Company Ltd, (SBIL)
SBIL is a joint venture between SBI and Cardiff S.A., a leading insurance company
in France and a 100 per cent subsidiary of BNP Paribas, the third largest bank in
Europe. The authorized capital of SBIL is 250 crore, and the paid-up capital of
125 crore is owned by SBI, 74 per cent and Cardiff, 26 per cent. The company
was licensed by the Insurance Regulatory and Development authority in March
2001.
SBI General Insurance Company Limited
SBI General Insurance Company Limited is a joint venture between the State
Bank of India and Insurance Australia Group (IAG). SBI owns 74 per cent of the
total capital and IAG the remaining 26 per cent.
SBI General is in the process of setting up a unique multi-distribution model
encompassing Bancassurance, Agency, Broking & Retail Direct channels.
Bancassurance will be the major channel during the initial years.
SBI General’s current geographical coverage extends to 20 cities pan India
and plans are on to extend this reach to another 25 cities by mid-2012. The
company is currently serving 3 key customer segments, i.e., Retail Segment
(catering to Individual & Families), Corporate Segment (catering mid to large size
Companies) and SME segment. In a short span, SBI General has emerged as one
of the few General Insurance companies in India to have a dedicated SME Team
catering exclusively to the needs of SME segment.
Current Policy offering of SBI General covers Motor & Home Insurance
for Individuals and Fire, Marine, Package, Construction & Engineering, Group
Health & Miscellaneous Insurance for Businesses.
Clearing Corporation of India Ltd (CCIL)
CCIL having an authorized capital of 50 crore was set up with the SBI as the
chief promoter with an equity holding of 26 per cent. CCIL commenced operations
from February 2002. The setting-up of CCIL is expected to deepen and widen
the debt market and impart to it the much needed liquidity; it will also facilitate
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retailing in government securities. The Reserve Bank of India has made it State Bank of India
compulsory to route individual trades in government securities up to 20 crore

through CCIL.
The State Bank of India (Subsidiary Banks Laws) NOTES
Amendment Act, 2007
The State Bank of Hyderabad Act, 1956 and the State Bank of India (Subsidiary
Banks) Act, 1959 were amended in 2007 with a view to:
(i) remove the difficulties faced by the shareholders of the subsidiary banks of
the State Bank of India;
(ii) facilitate increase in the capital of the subsidiary banks and
(iii) enable subsidiary banks to raise resources from the market.
The Act which came into force with effect from 9 July 2007 amended the
said Acts, inter alia to:
(i) increase the authorized capital of subsidiary banks to 500 crore and
divide the authorized capital into shares of one hundred rupees each
or of such denomination as may be decided by the subsidiary banks,
with the approval of the State Bank of India;
(ii) allow the subsidiary banks to issue share certificates of such
denomination as may be prescribed by regulations made by the State
Bank of India with the approval of the Reserve Bank of India to the
existing shareholders;
(iii) allow the subsidiary banks to raise issued capital through preferential
allotment or private placement or public issue in accordance with the
procedure as may be specified by regulations made by the State Bank
of India with the approval of the Reserve Bank of India and to issue
preference shares in accordance with the guidelines framed by the
Reserve Bank of India;
(iv) allow reduction of the State Bank’s shareholding in the subsidiary banks
from 55 per cent to 51 per cent;
(v) remove the restriction on individual shareholdings in excess of two
hundred shares and increase the percentage of voting rights of
shareholders (other than the State Bank of India) from one per cent to
ten per cent of the issued capital of the subsidiary bank concerned;
(vi) enable the Reserve Bank of India to nominate one director, possessing
necessary expertise and experience in the matter relating to regulation
or supervision of commercial banks, and to make provision for
nomination of additional director by the Reserve Bank of India as and
when considered necessary, in the interest of banking policy and
depositors’ interest;
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State Bank of India (vii) increase the number of elected directors representing shareholders of
subsidiary bank limited to a maximum of three, subject to different
percentage of public ownership;
(viii) specify the qualification regarding eligibility criteria including ‘fit and
NOTES
proper’ criteria for elected directors of subsidiary bank and to confer
power upon the Reserve Bank of India to remove elected directors
who are not ‘fit and proper’ and also to allow the board of directors
of a subsidiary bank to co-opt any other person who is ‘fit and proper’
in his place;
(ix) confer power upon the Reserve Bank of India to supersede the board
of directors of subsidiary banks in public interest or depositors’
interest, or for securing proper management of the subsidiary banks
on the recommendation of the State Bank of India and to appoint an
administrator and a committee to assist the administrator;
(x) enable the board of a subsidiary bank to frame regulation after
consultation with the State Bank of India and with the previous
approval of the Reserve Bank of India;
(xi) enable the banks to hold board meeting through video-conferencing
or such other electronic means and
(xii) entitle the shareholders present in the annual general meeting to adopt
the balance sheet.
The State Bank of India (Amendment) Bill, 2010
The State Bank of India (Amendment) Bill, 2010 seeks to amend the State Bank
of India Act, 1955. The Bill, inter alia, provides for:
(i) Raising the authorized capital of the State Bank of India to 5,000 crore;
(ii) The issued capital of the State Bank of India to consist of equity shares or
equity and preference shares;
(iii) Allowing the State Bank of India to raise the issued capital by preferential
allotment or private placement or public issue or frights issue;
(iv) Allowing the State Bank of India to issue bonus shares to existing equity
shareholders;
(v) Reducing the shareholding of the Central Government from 55 per cent to
51 per cent consisting of equity shares of issued capital;
(vi) Providing nomination facility in respect of shares held by individuals or joint
share holders;
(vii) Restricting the voting rights of preference share holders only to resolutions
affecting their rights and also restricting the preference shareholders, other
than Central Government to exercising voting rights in respect of preference
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shares held by them to a ceiling of ten per cent of total voting rights of all State Bank of India
preference share holders;

(viii) Specifying qualifications for directors elected by shareholders of the State
Bank of India and conferring power upon the Reserve Bank of India to
NOTES
notify the fit and proper criteria for such directors;
(ix) Empowering the Reserve Bank of India to appoint additional directors as
and when it is considered necessary;
(x) Conferring upon the Central Government the power to supersede the Central
Board of the State Bank of India in certain cases on the recommendations
of the Reserve Bank of India and to appoint an Administrator;
(xi) Allowing the State Bank of India to hold their Central Board meetings through
video-conferencing or other electronic means;
(xii) Allowing the Central Government to appoint not more than four Managing
Directors in consultation with the Reserve Bank of India; and
(xiii) Abolish the post of Vice-Chairman.
The Bill has been passed by both the Houses of Parliament in August 2010.
Check Your Progress

1. Which is the oldest and the largest commercial bank in India?
2. When was the Reserve Bank of India established?
3. What is SBI General Insurance Company Limited?

QUESTIONS
1. The State Bank of India is the oldest and the largest commercial bank in
India.
2. The Reserve Bank of India was established in 1935.
3. SBI General Insurance Company Limited is a joint venture between the
State Bank of India and Insurance Australia Group (IAG).
9.5 SUMMARY
 The State Bank of India has a history of almost two centuries. It originated
with the establishment of the Imperial Bank of India. The Bank, in its present
form, came into existence in 1955 through the nationalization of the Imperial
Bank of India.
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State Bank of India  Management of the State Bank of India is vested with a Central Board.
There are also local boards at Mumbai, Kolkata, Chennai and New Delhi.
 The main objective in nationalizing Imperial Bank of India has been the
setting up of a strong state-partnered banking institution with an effective
NOTES
machinery composed of a large network of branches over the whole country.
 The State Bank of India is the only Indian bank that figures in Fortune top
100 banks.
 In addition to banking services, the Bank offers a whole array of financial
services.
 The Bank has adopted and is pursuing vigorously its information technology
policy.
 The Central Board is primarily responsible for management of risk.
 The Bank plays a vital role in priority sector, export credit and agricultural
financing.
 The Bank is the founder and the flagship member of the State Bank Group.
9.6 KEY WORDS
 Risk: Risk is the potential of gaining or losing something of value. Values

can be gained or lost when taking risk resulting from a given action or
inaction, foreseen or unforeseen.
 Management: Management includes the activities of setting the strategy
of an organization and coordinating the efforts of its employees (or of
volunteers) to accomplish its objectives through the application of available
resources, such as financial, natural, technological, and human resources.
 Credit: Credit is a contractual agreement in which a borrower receives
something of value now and agrees to repay the lender at some later date
with consideration.

EXERCISES
1. Write a short note on the origin of the State Bank of India.
2. Give the reasons for the nationalization of the Imperial Bank of India.
3. Give a short description of the information technology policy of the State
Bank of India.
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4. Write a short note on the risk management by the State Bank of India. State Bank of India
5. What is ‘entrepreneur scheme’ of the State Bank of India?

6. What is ‘stree shakti package’ of the State Bank of India?
7. What is ‘SME Credit Plus’ of the State Bank of India? NOTES
8. Give a brief description of ‘Kisan Credit Card’ of the State Bank of India.
9. Write a short note on the ‘State Bank Group’.
10. Outline the salient features of the State Bank of India (Amendment) Bill,
2010.
1. Discuss the role of the State Bank of India in the priority sector.
2. Examine the role of the State Bank of India in the field of export credit.
3. Discuss the role of the State Bank of India in agricultural banking.
4. Discuss the risk governance structure of the State Bank of India.
5. Examine the State Bank of India (Subsidiary Banks Laws) Amendment
Act, 2007.

Delhi.
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Regional Rural and
Cooperative Banks BLOCK - III
in India
BANKS REGIONAL SET AND RRB
NOTES
UNIT 10 REGIONAL RURAL AND
COOPERATIVE BANKS IN
INDIA
Structure
10.0 Introduction
10.1 Objectives
10.2 Functions, Role and Performance
10.2.1 Rural Cooperatives: Short-Term and Long-Term Structure
10.4 Summary
10.5 Key Words
10.0 INTRODUCTION
Regional rural banks were started to work in rural perspectives so that they can
lend more to farmers who are in need for money.
Urban cooperative banks are registered under Cooperative Societies Acts
of the respective state governments. Prior to 1966, UCBs were exclusively under
the purview of the state governments. Effective from 1 March 1966, certain
provisions of the Banking Regulation Act have been made applicable to these
banks. Consequently, the Reserve Bank of India became the regulatory and
supervisory authority of UCBs for their banking related operations. Managerial
aspects of such banks continue to remain with the state governments under the
respective Cooperative Societies Acts. UCBs with multi-presence are regulated
by the Central Government and registered under the Multi-state Cooperative
Societies Act.
10.1 OBJECTIVES

 Understand the roles and functions of regional banks
 Discuss the functions of rural banks
 Describe the functions of cooperative banks
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172 Material
Regional Rural and
10.2 FUNCTIONS, ROLE AND PERFORMANCE Cooperative Banks
in India
The client profile of cooperative and RRBs today predominantly comprise of priority
sector segments viz. Crop loans to farmers, Small business establishments, SSIs, NOTES
retail traders, professionals, self-employed persons and SRTOs, etc. who would
not normally find it easy to have access to large commercial banks. In urban areas,
however, there are a number of under banked people like artisans, labourers,
small business men, retailers, etc. of smaller means who find it difficult to organize
themselves in keeping with the requirements of modern times. It is highly desirable
on social as well as on economic grounds, that members of this class be enabled
to be covered into the banking fold and the cooperative banks and RRBs certainly
can take a lead into this.
The RRBs have played a key role in rural institutional financing in terms of
geographical coverage, clientele outreach, business volume and contribution to
the development of the rural economy. Between 1975 and 1987, 196 RRBs were
established. From a modest beginning of 17 branches covering 12 districts of the
country in December 1975, they grew to 14,446 branches in 518 districts of the
country by the end of June 2005. The RRBs have been in sharp focus over the last
few years with several measures initiated towards strengthening them and making
them vibrant channels of credit delivery, particularly for the rural sector. The most
prominent of these has been the process of state-wise amalgamation of RRBs
sponsored by the same sponsor bank. The process of amalgamation, initiated in
2005, is now nearing completion. As a result of the amalgamation process, the
number of RRBs in the country declined from 196 to 96 at the end of March 2007
and further to 88 at the end of June 2008.
The High Power Committee on Urban Cooperative Banks (1999) made a
number of recommendations concerning the regulatory aspects in relation to UCBs.
A Profile of UCBs
The urban co-operative banking sector comprises a number of institutions which
vary in terms of their size, nature of business and geographic spread. UCBs play
an important role by providing banking services to the wider sections of the society,
especially in rural and semi-urban areas. During the period 1991–2004 the UCB
sector witnessed substantial growth possibly encouraged in post reform period.
Alongside, a number of entities became weak and unviable, eroding public
confidence and posing systemic risk to the sector. Keeping in view the heterogeneity
of this sector, the Reserve Bank of India proposed a multi-layered regulatory and
supervisory approach specifically aimed at revival and strengthening of UCBs in
the Vision Document for UCB sector, 2005. In the Vision Document, details of
which are given subsequently, the Reserve Bank of India proposed merger/
amalgamation of viable entities within the sector and non-disruptive exit of the
unviable ones. In the recent years there has been a decrease in total number of
UCBs as an outcome of the ongoing consolidation process in this sector. As at Self-Instructional
Material 173
Regional Rural and end-March, 2011, there were 1,645 UCBs with deposits amounting to 2,12031
Cooperative Banks
in India and advances amounting to 1,36341. Grade-wise distribution of UCBs. UCBs
are classified into four grades, namely Grade I, II, III and IV, in the order of their
performance assessment based on capital adequacy, level of NPAs, history of
NOTES profit/loss, among others. UCBs categorized as Grade I and II are considered
financially stronger than that of Grade III and IV. As an outcome of the ongoing
consolidation process of the UCB sector in the form of merger/acquisition among
financially viable banks and exit of the non-viable ones, there was a concentration
of number of UCBs in Grade I and II categories in recent years. The percentage
of banks in Grade I and II together constituted 82 per cent of total UCBs as at
end-March 2011. The share of banking business also witnessed a concentration
in favour of financially sound UCBs in the recent past. The shares of deposits as
well as advances of UCBs in grade I and II together were 89.5 and 89.9 per cent
of total deposits and advances of UCBs, respectively, at end-March 2011.
An analysis of performance of the UCB sector according to assets, deposits
and advances size-wise confirmed that there was concentration of business in favour
of UCBs with larger asset size. As at end-March 2011, UCBs with asset size more
than 500 crore constituted 6 per cent of total number of UCBs while the same
category of UCBs accounted for a share of 50 per cent of total assets of the sector.
UCBs with medium asset size ( 100–500 crore) had a share of 21 per cent of total
number of UCBs and 12 per cent of total asset size. The remaining share of 14 per
cent of total assets was attributable to UCBs with smaller asset size ( 15–100
crore), which accounted for almost 73 per cent of the total number of UCBs.
An analysis of deposits and advances base-wise distribution of UCBs
revealed that banking business was predominantly concentrated in favour of larger
UCBs. UCBs with larger deposit base (more than or equal to 500 crore), though
accounted for only 4 per cent of total number of UCBs, contributed almost 53 per
cent of total deposits. Similarly, only 3 per cent of total number of UCBs had
advances base of more than 500 crore, but they accounted for almost 47 per
cent total advances disbursed in 2010–11.
Apart from grade-wise classification, UCBs are classified into two
categories, viz., Tier I and Tier II for regulatory purposes. All UCBs which followed
the below stated criteria are classified as Tier I banks while all other banks are
classified as tier II banks:
1. Banks having deposits below 100 crore operating in a single district.
2. Banks with deposits below 100 crore operating in more than one district
provided the branches are in contiguous districts and, deposits and
advances of branches in one district separately constitute at least 95 per
cent of total deposits and advances, respectively of the bank.
3. Banks with deposits below 100 crore, whose branches were originally
in a single district but subsequently became multi-district due to
reorganization of the district.
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174 Material
There was an increase in the number of tier II banks while the number of tier Regional Rural and
Cooperative Banks
I banks reduced. As at end-March 2011, tier I banks accounted for more than in India
three-fourths of total number of UCBs. As against this, their share in total deposits
as well as advances were less than 20 per cent. Tier II banks, though constituted
less than one-fourth of total number of banks, accounted for majority share of NOTES
advances and deposits. Similarly, the distribution of total assets was also heavily
skewed in favour of tier II banks with these banks accounting for almost 81 per
cent of total assets of the UCB sector.
Capital adequacy
As at end-March 2011, almost 90 per cent of the UCBs were found to have
CRAR of more than 9 per cent. However, almost 20 per cent of the scheduled
UCBs failed to comply with the prescribed minimum CRAR of 9 per cent whereas
their non-scheduled counterparts performed better in terms of capital adequacy
with only 8 per cent of them reporting CRAR below the prescribed limit.
Refinance Facilities
The RBI extends refinance to UCBs at bank rate against their advances to tiny
and cottage industrial units. Since 2000–01, NABARD has designated scheduled
UCBs as eligible institutions for drawing refinance in respect of loans issued for
rural non-farming sector, including rural housing and other non-agricultural activities.
Priority Sector Lending
UCBs are required to channelize 60 per cent of total loans and advances towards
priority sector. Furthermore, within the priority sector lending, lending to weaker
sections should constitute 15 per cent of the total loans and advances of UCBs.
Fulfilment of priority sector lending targets are taken into consideration by the RBI
while granting permission for branch expansion, expansion of areas of operation,
scheduled status, etc.
Based on the revised guidelines on the priority sector issued in August 2007,
52.7 per cent of cash advances were extended to the priority sector by UCBs.
Small enterprises constituted the largest share (16.9 per cent of the priority sector
lending followed by housing loans (13.4 per cent) and retail trade (11.5 per cent).
Lending to the weaker sections constituted 13.7 per cent of advances.
The priority sector lending target for UCBs was brought down to 40 per
cent of the adjusted bank credit (ABC) (total loans and advances plus investments
made by UCBs in non-SLR bonds) or credit equivalent of off-balance-sheet
exposure (OBE), whichever is higher, as on 31 March of the previous year and
thus brought at par with the target applicable to commercial banks. The revised
target came into effect from 1 April 2008. Sectors that qualify for inclusion as
priority sectors now include:
(i) total agricultural credit (both direct and indirect);
(ii) total credit to small enterprises (direct and indirect); Self-Instructional
Material 175
Regional Rural and (iii) retail trade;
Cooperative Banks
in India (iv) micro credit;
(v) state sponsored organizations for SC/ST;
NOTES (vi) education and
(vii) housing.
As at end-March 2011, advances to priority sectors by the UCBs constituted
almost 46 per cent of the total advances disbursed by them. Of this, small enterprises
and housing loans constituted almost 59 per cent and 26 per cent, respectively, of
total priority sector advances.
Conclusion
Recognizing the importance of UCBs in providing banking services to the middle
and lower income group of people, the RBI in March 2005 drafted a Vision
Document for UCBs, pointing out the problem of dual control as a restrictive
mechanism, inhibiting its ability to handle the weaknesses of the entities within the
sector. The details of the Vision Document are given in the following section.
Draft Vision Document for Urban Cooperative Banks
Urban Cooperative Banks (UCBs) are an important part of the financial system in
India. It is, therefore, necessary that the UCBs emerge as a sound and healthy
network of jointly owned, democratically controlled, and ethically managed banking
institutions providing need-based quality banking services, essentially to the middle
and lower middle classes and marginalized sections of the society. This document
sets out the broad approach and strategies that need to be adopted to actualize
this vision.
1. Background
(a) The urban cooperative banking system has witnessed phenomenal growth
during the last one and a half decades. From 1307 urban cooperative banks
(UCBs) in 1991, the number of UCBs has risen to 2105 in the year 2004.
Deposits have increased by over 1100 per cent from 8,600 crore to over
100, 000 crore, while advances have risen from 7,800 crore to over
65,000, i.e., by 733 per cent during the above 15-year period. This growth
path has been possible mainly on account of the enabling policy environment
in the post 1991 period, which encouraged setting-up of new urban
cooperative banks. Further, the deregulation of interest rates, as available
to commercial banks, enabled the UCBs to mobilize vast deposits, which,
together with the liberal licencing policy propelled the growth of UCBs in
terms of numbers as also in size. This significant growth in business, which
has come about in a competitive environment was largely due to the efforts
and the ability of the sector to harness resources from the small depositors.
(b) Thus, while the sector has shown spectacular growth during the last decade
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exhibiting substantial potential for sustained growth, there are certain
176 Material
infirmities in the sector that have manifested in the form of weakness of Regional Rural and
Cooperative Banks
some of the entities resulting in erosion of public confidence and causing in India
concern to the regulators as also to the sector at large. There is, thus, a
need to harness the benefit of rapid growth and mitigate the risk to which
individual banks and the system are exposed by providing a regulatory and NOTES
supervisory framework that will address the problems of the sector as also
the shortcomings of dual control.
2. Objective
(a) In the light of above, the broad objectives of the document can be set out as
under:
(i) To rationalize the existing regulatory and supervisory approach keeping
in view the heterogeneous character of entities in the sector.
(ii) To facilitate a focussed and continuous system of supervision through
enhanced use of technology.
(iii) To enhance professionalism and improve the quality of governance in
UCBs by providing training for skill upgradation as also by including
large depositors in the decision-making process/management of banks.
(iv) To put in place a mechanism that addresses the problems of dual
control, given the present legal framework, and the time consuming
process in bringing requisite legislative changes.
(v) To put in place a consultative arrangement for identifying weak but
potentially viable entities in the sector and provide a framework for
their being nurtured back to health including, if necessary, through a
process of consolidation.
(vi) To identify the unviable entities in the sector and provide an exit path
for such entities.
3. The Operating Environment
(a) Urban cooperative banks form a heterogeneous group in terms of
geographical spread, area of operation, size or even in terms of individual
performance. As such, development of the urban cooperative banking
institutions into safe and vibrant entities requires the small banks in the group
to be insulated from systemic shocks by emphasizing their cooperative
character. Further, the weak banks may have to be strengthened as a group,
through a process of consolidation that may entail mergers/amalgamations
of viable entities and exit of the unviable ones, if there are no other options
available. It is also felt that it is necessary to set up a supervisory system that
is based on an in-depth analysis of the heterogeneous character of the urban
cooperative banks and one that is in tandem with the policy of strengthening
the sector.
Self-Instructional
Material 177
Regional Rural and 4. Structures and Spread of UCBs
Cooperative Banks
in India
In terms of geographical spread, UCBs are unevenly distributed across the states.
Five states, viz., Maharashtra, Gujarat, Karnataka, Andhra Pradesh and Tamil
NOTES Nadu account for 1523 out of 1924 banks that presently comprise the sector.
Further, the UCBs in these states account for approximately 82 per cent of the
deposits and advances of the sector.
For all UCBs in the country, the total deposits are 1,10,25,642 lakh and
total advances are 67,93,017 lakh.
5. Regulatory Environment
The urban cooperative banks are regulated and supervised by State Registrars of
Cooperative Societies, Central Registrar of Cooperative Societies in case of multi-
state cooperative banks and by Reserve Bank. The Registrars of Cooperative
Societies of the states exercise powers under the respective Cooperative Societies
Act of the states in regard to incorporation, registration, management,
amalgamation, reconstruction or liquidation. In case of the urban cooperative banks
having multi-state presence, the Central Registrar of Cooperative Societies, New
Delhi, exercises such powers. The banking related functions, such as issue of
licence to start new banks/branches, matters relating to interest rates, loan policies,
investments, prudential exposure norms, etc., are regulated and supervised by the
Reserve Bank of India under the provisions of the Banking Regulation Act,
1949(AACS). Various committees in the past, which went into working of the
UCBs, have found that the multiplicity of command centres and the absence of
clear-cut demarcation between the functions of state governments and the Reserve
Bank have been the most vexatious problems of urban cooperative banking
movement. This duality of command is largely responsible for most of the difficulties
in implementing regulatory measures with the required speed and urgency and
impedes effective supervision.
6. Strategy—State Specific Approach
The strategy to deal with the UCBs may need to be state specific, one that involves
the concerned state government, RBI and the UCBs operating in the state. A state
level Task Force on Cooperative Urban Banks (TAFCUB) comprising the Regional
Director (RD) of the RBI for the concerned state, Registrar of Cooperative
Societies, an official from Central Office of Urban Banks Department (UBD), in-
charge of UBD of the concerned Regional Office of RBI and a representative
each from NAFCUB and the State Federation of the UCBs, could be set up, in
each of the five states with high concentration of UCBs and in a few other states
having, say, more than 50 banks to explore viable state specific solutions, including,
on the future set up of the existing unlicenced banks whose licence applications
are pending with the RBI. Similar approaches may be considered for other states
in a second phase after assessing the working of the state specific approach in the
five states and in states with more than 50 UCBs. However, if any state prefers to
Self-Instructional
178 Material
adopt the approach in the first phase itself, RBI could consider the proposal Regional Rural and
Cooperative Banks
appropriately. in India
The Regional Director (RD) of the RBI and RCS of the concerned state
could be the Chairman and co-chairman of TAFCUB, respectively. Each TAFCUB
NOTES
could identify the weak but viable (non-scheduled) UCBs in the respective states
and frame a time bound programme for revival of such entities. It would identify
the nature and extent of funds required to be infused, the changes in management
where necessary and suggest periodical milestones to be achieved. The RBI would
closely monitor the progress made by the bank vis-à-vis the revival plan and
initiate appropriate action, in case of non-achievement of the targets, as per the
plan. Further, UCBs which are not found viable by the TAFCUB, could be required
to exit from banking business either through merger with strong banks, if such
merger makes economic sense to the acquiring bank, or through voluntary
conversion into a cooperative society by paying off the non-member deposits and
withdrawing from the payment system and if there is not other viable option they
could even be taken into liquidation by the Registrar at the behest of the RBI.
The guidelines on merger and amalgamations (M&A) of UCBs have been
issued. These guidelines provide that Reserve Bank of India may consider proposals
for merger and amalgamation in the following circumstances:
(i) When the networth of the acquired bank is positive and the acquirer
bank assures to protect entire deposits of all the depositors of the
acquired bank.
(ii) When the networth of acquired bank is negative and the acquirer bank
on its own assures to protect deposits of all the depositors of the
acquired bank.
(iii) When the networth of the acquired bank is negative and the acquirer
bank assures to protect the deposits of all the depositors of the acquired
bank with financial support from the state government extended upfront
as part of the process of merger.
In all cases of merger/amalgamation the financial parameters of the acquirer
bank, post merger, should conform to the prescribed minimum prudential and
regulatory requirement for urban cooperative banks and the realizable value of
assets has to be assessed through a process of due diligence. TAFCUB shall
make suitable recommendations on M&A based on the above guidelines.
7. Memorandum of Understanding with State Governments
As per provisions of the State Cooperative Societies Act as also the BR Act 1949
(AACS), the Reserve Bank is not empowered to take action against the
management of an urban cooperative bank, in case of need, as in respect of
commercial banks. It may be useful to have a working arrangement in the form of
Memorandum of Understanding (MoU) between the RBI and the State
Government/CRCS to ensure that the difficulties caused by dual control are suitably
Self-Instructional
Material 179
Regional Rural and addressed through such MoU/s. The state governments may, through the MoU,
Cooperative Banks
in India agree to take immediate action on requisitions of RBI for supersession of the
Board of Directors, appointment of liquidators, initiating action for removal of
CEO/Chairman of a bank, enhancing quality of HR and IT resources in the banks
NOTES on the lines required by RBI, work to raise the standards of corporate governance
by putting in place certain minimum fit and proper criteria for members to be
eligible for seeking election for the post of director, institute special audit by
Chartered Accountants, the cost of which may be borne by the RBI, and furnish
reports of the findings within a given time frame, introduce long form audit reports
for conducting statutory audit, modify its audit rating models to bring it on par with
the gradation system of RBI, conduct statutory audit only through external Chartered
Accountants in respect of banks with deposits over a specified minimum level etc.
The draft MoU is given in Annexure—I. The TAFCUBs would be set up in states
that sign the MoUs with the RBI. In respect of the states that sign the MoU but do
not fulfil the commitments therein, the TAFCUB would cease to function and RBI
would be at liberty to initiate appropriate corrective action.
8. Proposed Operating Framework
The entities in the sector display a high degree of heterogeneity in terms of their
deposit/asset base, area of operations and nature of business. A system of
differentiated regulatory and supervisory regime as opposed to a ‘one size fits all’
approach may be more appropriate, keeping in view the vastly differentiated entities
comprising the sector. The broad principles governing RBI regulation over UCBs
could largely follow the principles as under:
(a) Unit Banks (Simplified regulatory regime): Unit banks, in particular, the
smaller among them, essentially capture the basic concept and spirit of
cooperative banking since they function from a single office/branch and cater
to the clientele in and around their place of business. As such, they have a
natural ability to relate to the customer, have the local feel and flavour and
consequently modulate their business strategy to meet the local aspirations.
Since small unit banks with deposits below, say, 50 crore epitomize the
basic tenets of cooperative banking, less stringent regulations could be
considered for such banks. For example, CRAR could be replaced by the
simpler form of minimum capital requirement, viz., Net Owned Funds to NDTL
ratio which is easier to compute for the small banks while serving the purpose
adequately. At the same time, keeping in view their ability to assess and absorb
risks, appropriate limitations like a lower level of single and group exposure
limit could be prescribed for these banks to contain their concentration risk.
Similarly, the exposure by such banks to sensitive sector should be checked,
as these banks lack the wherewithal, in terms of expertise, technology and
financial strength to sustain exposure to capital market/real estate etc. As
such, keeping in view the nature and size of their operations, appropriate
relaxations like a lower prescribed minimum investment in G-Sec (in view of
Self-Instructional their inability to access market) and restrictions necessary to insulate them
180 Material
from systemic shocks may be introduced for such banks. Ideally the unit Regional Rural and
Cooperative Banks
banks should work within a small geographical area and accordingly the Unit in India
banks to be eligible for the simplified regulatory regime shall conform to this
requirement by rolling back their business in far-off locations. The suggested
simplified regulatory prescriptions are given in Annexure—II. NOTES
(b) All banks (other than unit banks with deposits less than 50 crore)
Regulatory prescriptions, as applicable to commercial banks should be
applicable in all respects to banks falling in this category. However, for
these banks the extant relaxations for UCBs could remain in force for the
period already prescribed. Further, it is suggested that as a matter of principle,
there should not be any unscheduled Multi-State Bank. This could be
operationalized through the Central Registrar of Cooperative Societies, which
could ensure that a bank is scheduled before it is granted registration under
the Multi-State Cooperative Societies Act. In order to ensure that all
scheduled banks are also, as far as possible, strong enough to support
themselves and a few smaller UCBs around them, the RBI could prescribe
appropriate norms for scheduling of cooperative banks.
Further, banks in this category which comply with the prescribed regulatory
requirements can be extended facilities and privileges as are presently available to
the commercial banks of comparable size.
The existing scheduled banks, both under Multi-State and State Cooperative
Societies Act, which do not meet the prescribed criteria and do not comply with
the prudential and regulatory regimen akin to that of commercial banks, could be
excluded from the second schedule to the RBI Act through a time bound corrective
action framework As a corollary, the existing non-scheduled Multi-State Banks
could also be required to close their branches/withdraw from any business outside
the principal state of their activity.
9. Supervision
The number of unit banks with deposits under 50 crore constitute 33 per cent of
UCBs and account for less than 6 per cent of deposits of the sector. These banks,
limited by their size/type of operations, pose lower systemic risks and could be
supervised by a combination of simplified off-site surveillance system of the RBI
and on-site audit by the state governments. Based on these reports, Reserve Bank
of India, at its discretion, could conduct inspection of such banks, which, however
would not be normally covered under its regular schedule of inspection. The
increased dependence on off-site surveillance of RBI and on-site supervision by
RCS in respect of the small unit banks would provide increased flexibility to the
RBI to deploy its supervisory resources to the larger and more risky banks.
10. Developmental Role of RBI
The Reserve Bank may have to provide assistance to the UCBs, more particularly
the smaller ones, in improving their skill levels. Since the College of Agricultural Self-Instructional
Material 181
Regional Rural and Banking is already providing training facilities to the UCBs, this institution could
Cooperative Banks
in India be used as the forum for doing so. Keeping in view the financial implications for
banks, for providing quality training, the cost of training programmes could be
largely subsidized by the Reserve Bank for the Unit banks falling under Tier I.
NOTES
The Reserve Bank has been encouraging the UCBs to invest in government
securities by stipulating that a portion of the SLR investments are held in the form
of these securities. There is an inherent advantage in holding a part of the SLR
investments in G-Secs as otherwise the banks are required to keep their entire
SLR in higher tier cooperative banks, the financial position of which may itself be
uncertain. At the same time it would be necessary to ensure that the UCBs are not
put to any difficulty in buying and selling the securities. To address this issue Reserve
Bank may, through its Regional Directors, liaise with the network of Primary Dealers
to put in place an appropriate arrangement in this regard.
Conclusion
Every authority concerned with Cooperative sector will have to play its part in ensuring
that the aspirations of the Urban Cooperative Banking sector are nurtured in a manner
that depositor interest and the public interest at large is protected. The role of RBI
could, thus, be to frame a regulatory and supervisory regime that is multi-layered to
capture the heterogeneity of the sector and implement policies that would provide
adequate elbowroom for the sector to grow in a non-disruptive manner.
The State and Central Governments could recognize that the UCBs are not
just cooperative societies but they are essentially banking entities whose
management structure is that of a cooperative.
They should recognize the systemic impact that inefficient functioning of the
entities in the sector could have. Consequently, it would be in the interest of the
sector if they support, facilitate and empower the RBI to put in place mechanisms
and systems that would enable these UCBs to perform their banking functions in
a manner that is in the overall interest of the depositor and the public at large.
Appendix to Urban Coop. Banks
Draft terms of reference of the TAFCUB
1. To categorize the UCBs in the state under the two-tiers of regulatory regime.
2. To identify banks, which are viable, potentially viable and unviable.
3. To recommend the various conditions, including the nature and extent of
funds required to be infused, in each UCB identified as potentially viable,
the source thereof, changes in management where necessary and the time
frame for achieving viability. In doing so, the TAFCUB may assign
responsibility to different agencies for facilitating the turn-around.
4. To set up milestones for evaluation of progress made under the rehabilitation
plan.
Self-Instructional
182 Material
5. To recommend the future set up of the existing unlicenced banks whose Regional Rural and
Cooperative Banks
applications are pending with Reserve Bank of India. in India
6. To recommend the manner and time frame for exit of the unviable banks,
which could be in the form of merger/amalgamation, conversion into a credit
NOTES
society and liquidation.
The proposals for merger/amalgamation recommended by the TAFCUB
shall conform to the guidelines issued in this regard.
7. To arrive at a threshold limit of deposits that would make a depositor
automatically eligible to become a member.
8. To recommend on the management aspects of a bank which is placed under
the revival plan.
9. Any other issues as may be referred to it by the Reserve Bank of India.
Tier II (All other banks)
For all banks, other than unit banks with deposits upto 50 crore, all regulations
as applicable to commercial banks should be applied, However, for these banks
the extant relaxations for UCBs could remain in force for the period already
prescribed. Further, facilities and opportunities available to commercial banks
should, as far as possible, be also made available to such banks to enable them to
grow and compete with commercial banks. Banks that do not comply with the
regulations should either reduce their operations to qualify for the relaxed regulations
applicable for unit banks with deposits less than 50 crore or may be required to
convert into cooperative societies
As per the terms of the document, until 2008, 28 state governments and
Central Government (in case of multi-state UCBs) have signed the Memoranda of
Understanding (MoUs) with the RBI covering 98.6 per cent of the total number of
UCBs representing 99.2 per cent of deposits of the sector. As a part of the MoU,
the State Level Task Force for Cooperative Urban Banks (TAFCUBs) have been
set up to identify the potentially viable and non-viable UCBs in the State and to chart
out the revival path and non-disruptive exit route for the two sets of banks,
respectively. These measures instilled confidence in the sector which is evident from
the increase in deposits for three successive years, i.e., from 2005–06 to 2007–08.
During 2007–08, the RBI continued with its policy of encouraging states to
sign MoUs to establish a co-ordinated supervisory/regulatory structure, by further
adding incentives the scheme in the form of additional business opportunities, opening
of new ATMs and conversion of exchange counters into branches, among others.
The process of consolidation through mergers of UCBs progressed further in 2007–
08 with a total of 61 mergers being effected upon the issue of statutory orders by
the Central Registrar of Cooperative Societies/Registrar of Cooperative Societies
(CRCS/RCS) concerned. Further, as on 31 March 2008, 268 UCBs were under
various stages of liquidation. All these measures appear to have positive impact on
the performance of UCBs as a whole.
Self-Instructional
Material 183
Regional Rural and Urban Cooperative Banks’ Policy Developments
Cooperative Banks
in India
The cumulative mechanism adopted by the RBI for regulation and supervision of
the UCBs in line with the framework suggested in the Vision Document through
NOTES signing of MoUs helped strengthen the sector. Furthermore, the RBI guidelines on
merger/amalgamation of UCBs just prior to commencement of MoU process,
helped phase out non-viable banks through a non-disruptive exit route. Both of
these mechanisms progress well and help the UCB sector to strengthen further.
Besides, RBI continues with its policy of relaxed regulatory norms for Tier I UCBs,
i.e., smaller UCBs with deposit base of less than 100 crore and having branches
limited to a single district. Moreover, the RBI also made available a number of
facilities to UCB s in those states that have signed MoU with the RBI.
Regulatory and Supervisory Framework
The performance of the cooperative banking sector has been a cause for concern in
recent years in the context of financial sector reforms. Financial and managerial
weaknesses of cooperatives have been in evidence. It has been, therefore, felt
necessary to extend the essential spirit of the regulatory and supervisory measures to
the cooperative banks as well, with necessary adaptations to suit the circumstances
in which cooperative banks operate. It may be repeated in this connection that
among the rural cooperative banks, only the State Cooperative Banks and Central
Cooperative Banks are covered under the scope of the Banking Regulation Act.
The RBI is the regulatory authority for such banks while their supervision has been
entrusted to NABARD, which has concurrent power for the same.
High Power Committee on Urban Cooperative Banks
In order to make a comprehensive review of activities and regulatory framework
pertaining to UCBs, a High Power Committee was constituted by the RBI in May
1999 (Chairman being Shri K. Madhava Rao), to focus on the following issues:
(i) to evolve objective criteria to determine the need and potential for organizing
urban cooperative banks; review the existing entry point norms and examine
the relevance of special dispensations for less/least developed areas;
(ii) to review the existing policy pertaining to branch licensing and area of
operation of urban cooperative banks;
(iii) to consider measures for determining the future set up of weak/unlicensed
banks;
(iv) to examine the feasibility of introducing capital adequacy norms for urban
cooperative banks;
(v) to examine the need for conversion of cooperative credit societies into
primary cooperative banks and
(vi) suggest necessary legislative amendments to Banking regulation Act and
Cooperative Societies Acts of various States for strengthening the urban
Self-Instructional banking movement. The committee submitted its report in November 1999
184 Material
in which very useful recommendations have been made with regard to revision Regional Rural and
Cooperative Banks
of licencing policy for new PCBs, branch licencing policy, extension of areas in India
of operation, dealing with unlicensed and weak PCBs, application of capital
adequacy norms, conversion of cooperative societies into PCBs and reforms
in State Cooperative Acts, Multi-State Cooperative Societies Act and NOTES
Banking Regulation Act. The recommendations were aimed at:
(i) reducing systemic risk to the financial system;
(ii) putting in place strong regulatory norms at the entry level so as to sustain
and improve the operational efficiency of urban cooperative banks in a
competitive environment;
(iii) evolving measures to strengthen the existing structure, particularly in the
context of ever increasing number of weak banks and
(iv) aligning the PCB sector with other segments of the banking sector in the
context of application of prudential norms and removing the irritants of dual
control regime.
Major Recommendations
The major recommendations of the High Power Committee on Urban Cooperative
Banks are as under:
(a) Licensing Policy of New UCBs:
The regulator should prescribe the twin criteria for entry i.e., a strong start-up
capital and requisite norms for promoters’ eligibility. The existing quantitative criteria
for viability standards should be replaced by qualitative norms like CRAR, tolerance
limit of NPAs and operational efficiency. The committee prescribed five grades
(depending on population size of centre) of entry point norms (EPN) based on
centre-wise capital and membership.
(b) Corporate Governance:
At least two directors with suitable banking experience or relevant professional
background should be present on the Boards of UCBs and the promoters should
not be defaulters to any financial institution or banks and should not have any
association with chit fund/NBFC/cooperative bank or commercial bank in the
capacity of Director on the Board of Directors.
(c) Branch Licensing Policy and Area of Operation:
The Reserve Bank should extend to the UCBs the same freedom and discipline as
is applicable to commercial banks in opening branches, if a UCB complies with
the broad norms relating to capital adequacy, provisioning, net NPAs, profitability
and priority sector advances. Further, it should not be in default of any of the
provisions of the B.R. Act or RBI Act or Directives issued by the Reserve Bank.
Every UCB must submit to the Reserve Bank an Annual Action Plan (AAP).
Scheduled UCBs which satisfy the eligibility criteria would be given freedom to Self-Instructional
Material 185
Regional Rural and open new branches under the AAP. Non-scheduled UCBs should continue to
Cooperative Banks
in India obtain prior approval of the Reserve Bank after complying with the eligibility criteria.
(d) Extension of Area of Operation:
NOTES New UCBs can extend their area of operation to the entire district of their registration
and adjoining districts. When the UCB desires to open a branch in a district in a
state other than the district in which it is registered, it must have a net worth which
is not less than the EPN prescribed for the highest category centre in that state. If
a UCB desires to open a branch in a state other than the state in which it is
registered, it must have a net worth of not less than 50 crore.
(e) Policy on Unlicensed Banks:
Under the provisions of Section 5 (ccv) of B.R. Act, a primary credit society with
paid-up capital and reserves of 1 lakh and with main objective of carrying on
banking business, automatically secures status of an urban bank. The committee,
therefore, recommended amendment to the Act so as to prevent such automatic
transformation of primary credit societies into UCBs. The committee also
recommended that the licence should be given to a bank if it—
(i) attains minimum level of CRAR prescribed by the regulator;
(ii) has net NPAs not in excess of 10 per cent;
(iii) has made profits during each of the last 3 years and
(iv) has complied with the statutory framework of B.R.Act/Directive issued by
the Reserve Bank.
(f) Policy on Weak/Sick Banks:
Separate objective criteria—based on CRAR, net NPA and history of losses—
have been recommended for identification of weak and sick banks.
(g) Application of CRAR to UCBs:
UCBs should be subject to CRAR discipline in a phased manner with initially
lower CRAR norms prescribed for non-scheduled UCBs as compared to
scheduled UCBs. The committee has recommended uniform CRAR as applicable
to commercial banks for scheduled UCBs and 9 per cent in case of non-scheduled
UCBs by March-end 2003.
(h) Conversion of Cooperative Credit Societies into UCBs:
Such of the credit societies whose net worth is not less than the entry point capital
prescribed for new banks in that given centre, which have been posting profits
during each of the last 3 years, which have earned ‘A’ audit rating and whose
methods of operation are not detrimental to the interests of the depositors, may be
allowed to convert themselves into UCBs.
Self-Instructional
186 Material
(i) Legislative Reforms in Central and States Statutes: Regional Rural and
Cooperative Banks
in India
The application of certain provisions of B.R. Act, 1949 to UCBs in 1966 initiated
a regime of dual control resulting in the absence of clear cut demarcation between
the functions of the state governments and the Reserve Bank. Hence, the State NOTES
Government Acts should be so amended as to categorize the banking-related
functions and the functions of the state governments separately. Accordingly, Multi-
State Cooperative Societies Act, 1984, State Cooperative Societies Acts and
Banking Regulation Act should be amended.
Licensing Norms
Licensing policy for UCBs was revised in August 2000, in consonance with the
recommendations of the High Power Committee. The thrust of the new policy is on
strong start-up capital, professionalization of boards of management and corporate
governance. The revised entry point norms are based on population criterion.
According to the new norms, UCBs should have minimum capital of 4 crore and
membership of at least 3,000 if the population of the place where the UCB is being
established is more than 10 lakh. For population between 5–10 lakh, the minimum
share capital and membership requirements are 2 crore and 2,000, respectively.
For population between 1–5 lakh the corresponding minimum requirements are 1
crore and 1,500, respectively. For towns with population less than 1 lakh, the
corresponding minimum requirements are 25 lakh and 500, respectively. The number
of licensed UCBs increased from 1,849 to 1,937 between March-end 2000 and
March-end 2001. Between July 2000 and June 2001, licenses under Section 22 of
the Banking Regulation Act, 1949 (As Applicable to Cooperative Societies (AACS))
were issued to 18 new banks and 17 existing unlicensed UCBs.
Recent Regulatory Measures
During March 2001, certain UCBs faced liquidity and insolvency problems. A major
factor behind the problem had been non-adherence by these UCBs to prudential
norms prescribed by the Reserve Bank, such as lending to stockbrokers, exceeding
prudential exposure to single party/group and the limit on unsecured advances and
failure to meet inter-bank payment obligations. At the centre of the problem was a
multi-state scheduled UCB, which witnessed a sudden withdrawal of deposits.
The Reserve Bank felt that in the interest of financial stability, it was important
to take measures to strengthen the regulatory framework for the cooperative sector.
Issues such as removal of ‘dual’ control of the UCBs, laying down of clear-cut
guidelines for their management structure, enforcement of further prudential
standards in respect of access to uncollateralized funds, lending by the UCBs
against volatile assets, etc., were considered in this context. The Reserve Bank
identified the following areas for immediate regulatory response:
(a) the extent of access of the UCBs to call/notice money markets;
(b) the asset-liability management system of the UCBs;
Self-Instructional
Material 187
Regional Rural and (c) inter-bank exposure of the UCBs in the form of deposits maintained
Cooperative Banks
in India by one UCB with another and
(d) the maintenance of SLR portfolio by the UCBs.
NOTES In order to address these issues, the Reserve Bank has announced a series
of measures relating to UCBs in the April 2001 monetary and credit policy statement.
The salient features of these measures are given below.
(a) Lending to Stock Markets:
It is important to point out that even before the policy changes were initiated in April
2001, cooperative banks were neither permitted to invest directly in stock markets
nor to lend to stock brokers. They could, however, lend to individuals against pledge
of shares up to a certain limit. Available information revealed that a few UCBs ignored
these guidelines and established a nexus with certain stockbrokers in order to operate
in the stock market. In order to prevent any possible misuse in the future, Reserve
Bank had put a stop on lending by UCBs directly or indirectly against also advised
to unwind existing lending to stockbrokers or direct investment in shares on the
contracted dates. In response to representations received from UCBs and their
federations, the October 2001 mid-term review proposed to allow UCBs to grant
loans to individuals against security of shares, subject to certain conditions.
(b) Access to Call/Notice Money Markets:
In order to reduce the excessive reliance of some UCBs in the call money market,
it was announced that their borrowings in the call/notice money market on a daily
basis should not exceed 2.0 per cent of their aggregate deposits as at March-end
of the previous financial year. The freedom to lend in the call/notice money market,
however, continues.
(c) Inter-UCB Term Deposits:
As parking of funds by UCBs with other UCBs may pose a systemic risk, as a
safety precaution, UCBs were advised not to increase their term deposits with
other UCBs. The outstanding deposits with other UCBs as on 19 April 2001
have to be unwound before end of June 2002. UCBs may maintain current account
balances at their discretion with other UCBs to meet their day-to-day clearing
and remittance requirements.
(d) Maintenance of SLR:
UCBs are required to maintain their SLR equivalent to 25.0 per cent of net demand
and time liabilities (NDTL). They can maintain it in the form of investments in
government and other approved securities or as deposits with StCBs/CCBs. In the
April 2001 policy statement, it was announced that with effect from 1 April 2003 all
scheduled UCBs would need to maintain their entire SLR assets of 25.0 per cent of
NDTL only in government and other approved securities and that compliance with
CRR requirements on par with scheduled commercial banks would be prescribed in
Self-Instructional
188 Material
due course. All scheduled UCBs and non-scheduled UCBs with deposits of 25 Regional Rural and
Cooperative Banks
crore and above now have to maintain investments in government securities only in in India
Subsidiary General Ledger (SGL) Accounts with Reserve Bank or in constituent
SGL Accounts with public sector banks, Primary Dealers (PDs), scheduled
commercial banks, state cooperative banks and depositories. Non-scheduled UCBs NOTES
with deposits of less than 25 crore would have the facility of maintaining government
securities in physical or scrip form. The UCBs were required to achieve certain
higher proportion of their SLR holding in the form of government and other approved
securities as a percentage of their NDTL by 31 March 2002. In response to the
representations received from UCBs and their federations it has been proposed to
modify the time-frame for achieving the prescribed levels of SLR holding.
Apart from initiating the policy changes, the Reserve Bank has also addressed
the issue of dual control of UCBs. At present, three authorities are involved in
regulatory and promotional aspects concerning the UCBs—the Central Government
(in case of banks having multi-state presence), state governments and the Reserve
Bank. Doing away of dual control entails amendments to the Constitution of India,
which can be a long drawn legislative process. In view of this, the Reserve Bank
felt that one of the options that deserves to be seriously considered is setting up of
a new apex supervisory body which can take-over the entire inspection/supervisory
functions in relation to scheduled and non-scheduled UCBs. This apex body could
be under the control of a separate high-level supervisory board consisting of
representatives of the Central Government, state governments, the Reserve Bank
as well as acknowledged experts in the areas of cooperative banking, etc. The
body may be given the responsibility of inspection and supervision of UCBs and
ensuring their conformity with prudential, capital adequacy and risk-management
norms laid down by the Reserve Bank.
Much before the incidence of irregularities in the UCBs discussed above,
the Reserve Bank had appointed a High Power Committee (Chairman being Shri.
K. Madhava Rao), 1999, to review the performance of the UCBs and to suggest
necessary measures to strengthen this sector. The committee submitted its report
in the same year. The major recommendations of the committee were given earlier.
Structural Initiatives
Vision Document
A significant proposal of the Vision Document was to address the problem of dual
control of UCBs by signing of MoU between the Reserve Bank and the respective
state governments, and establishing a consultative forum for supervision of the
banks. Accordingly, the Reserve Bank approached the states having a large network
of UCBs for signing MoUs. Since June 2005, MoUs have been signed with 23
state governments (upto 20 October 2008) and with the Central Government in
respect of multi-state UCBs and TAFCUBs have been constituted in all such
states. The mechanism of TAFCUBs has been able to restore the confidence in
the UCB sector (Box.IV.1). Self-Instructional
Material 189
Regional Rural and Two-tier Regulatory Structures—Definition Amended
Cooperative Banks
in India
The definition of Tier I bank was amended with effect from 7 March 2008. Banks
falling under the following categories are classified as Tier I banks: (i) unit banks,
NOTES i.e., banks having a single branch/head office. MoU and TAFCUBs—Impact and
Progress
In order to ensure greater convergence of regulatory and supervisory policies
between the two regulators in the urban cooperative banking sector, viz., state
governments (Central Government in case of multi-state UCBs) and the Reserve
Bank, the latter pursued a policy of encouraging the state governments to sign a
Memorandum of Understanding (MoU) in this regard. Pursuant to this policy, as
on 20 October 2008, 23 States, viz., Gujarat, Andhra Pradesh, Karnataka,
Madhya Pradesh, Uttarakhand, Rajasthan, Chhattisgarh, Goa, Maharastra,
Haryana, National Capital Territory of Delhi, West Bengal, Assam, Tripura, Punjab,
Uttar Pradesh, Manipur, Meghalaya, Himachal Pradesh, Kerala, Mizoram, Tamil
Nadu and Sikkim have signed MoUs with the Reserve Bank. The MoU has also
been signed with Central Government in respect of multi-state UCBs. As on 20
October 2008, the MoU has covered 1,746 UCBs out of 1,770 which accounts
for 98.6 per cent of total number of UCBs and 99.2 per cent of total deposits as
well as advances of the sector. As per the arrangements under MoU, the Reserve
Bank constitutes state level Task Force for Cooperative Urban Banks (TAFCUB)
comprising representatives of the Reserve Bank, the state government and the
UCB sector. Accordingly, TAFCUBs have been constituted in all states that have
signed MoUs. A Central TAFCUB has also been constituted for the multi-state
UCBs. TAFCUBs identify potentially viable and non-viable UCBs in the states
and suggest revival path for the viable and non-disruptive exit route for the non-
viable ones. The exit of non-viable banks could be through merger/amalgamation
with stronger banks, conversion of them into societies or liquidation, as the last
option. TAFCUBs, since its inception, have examined the position of 949 UCBs
(Including cases of banks reviewed more than once) and taken decision on finalising
merger with respect to 14 banks. Orders of directions by the Reserve Bank were
imposed on 37 banks and licences were cancelled for 40 banks.
Consolidation and Strengthening of the UCB Sector
Weak financial position of a number of UCBs has been the major concern in the
UCB sector for decades. The dual regulatory control over the sector contributed
a lot to the weak financial position of this sector. To address this issue, the Reserve
Bank of India in March 2005 prepared a vision document and based on that a
Medium-Term Framework (MTF), which envisaged regulatory coordination
between the two main regulatory authorities of the urban cooperative banking
sector, viz., the Reserve Bank of India and the respective state governments (central
government for multi-state UCBs) through signing of a Memorandum of
Understanding (MoU) in each state within the existing legal framework.
Self-Instructional
190 Material
MoUs have been entered into with the central government and all the 28 Regional Rural and
Cooperative Banks
states having presence of UCBs, thus covering the entire UCB sector. Task Force in India
for Cooperative Urban Bank (TAFCUBs) have been constituted in all these states
and a central TAFCUB has also been constituted for the multi-state UCBs. The
supervisory actions taken on the basis of the recommendations of TAFCUBs NOTES
include cancellation of licenses or rejection of license applications of unviable UCBs,
supersession of errant Board of Directors, and placing/modification of operational
restrictions/directions on the banks. Other important policy measures that were
implemented based on a consensus in the TAFCBUs were Guidelines on ‘Fair
Practice Code for Lenders’ and issue of guidelines on ‘Fit and Proper Criteria’ for
appointment of CEOs of UCBs. Further, TAFCUBs identify the potentially viable
UCBs and suggest solutions for their revival while formulating non-disruptive exit
strategies for non-viable banks. The exit of non-viable banks could be through
merger/amalgamation with stronger banks, conversion into societies or liquidation,
as the last option. With a view to facilitating consolidation, and non-disruptive and
orderly resolution of weak/unviable entities in the UCB sector, the Reserve Bank
of India had framed in February 2005 guidelines for merger/amalgamation of UCBs.
In terms of these guidelines, the acquirer bank has to protect deposits of the
acquired bank on its own or with upfront financial assistance from the state
government. In order to give a fillip to the process of mergers and consolidation of
the sector and to address the legacy cases of UCBs with negative net worth as on
31 March 2007, the Reserve Bank of India issued in January 2009 additional
guidelines for merger/amalgamation of UCBs which provided for DICGC support
to the extent and in the manner prescribed under Section 16 (2) of the DICGC
Act, 1961, financial contribution by the acquirer bank and sacrifice of a portion of
their deposits by large depositors.
As an additional option for resolution of weak UCBs, where proposals for
mergers are not forthcoming from within the UCB sector, guidelines were issued
by the Reserve Bank of India in February 2010 for sanction of a scheme of transfer
of assets and liabilities of UCBs (including branches) to commercial banks with
DICGC support, in legacy cases of banks with negative net worth. These guidelines
provide for 100 per cent protection to all depositors and DICGC support is
restricted to the amount provided under Section 16 (2) of the DICGC Act, 1961.
UCBs which had negative net worth as on 31 March 31 2007 or earlier and
continue to have negative net worth as on the date of transfer would be considered
eligible under the scheme.
As an incentive, the Reserve Bank of India would permit the transferee
(Commercial) bank to take over branches of the transferor bank (UCB) with the
prior approval of the Reserve Bank of India. The shifting/relocation of branches of
the transferor bank may also be permitted by the Reserve Bank of India subject to
banking facilities being made available to customers through the existing/relocated
branches of the transferor/transferee bank.
Self-Instructional
Material 191
Regional Rural and 10.2.1 Rural Cooperatives: Short-Term and Long-Term Structure
Cooperative Banks
in India
Rural cooperative credit institutions include state cooperative banks (StCBs),
district central cooperative banks (DCCBs), primary agricultural credit societies
NOTES (PACs), state cooperative agriculture and rural development banks (SCARDBs)
and primary cooperative agriculture and rural development banks (PCARDBs).
Recognising the wide outreach of rural cooperative credit institutions, particularly
among the rural and vulnerable segments of the society, and their role in purveying
rural credit and deposit mobilization, efforts are being made to restore operational
viability and financial health of those institutions. The financial performance of rural
cooperative credit institutions is characterized by several weaknesses such as high
NPAs, poor recovery and accumulated losses. As on 31 March 2007, four out of
31 StCBs, 97 out of 371 DCCBs, 48,078 out of 97,224 PACs, eight out of 20
reporting SCARDBs and 342 out of reporting 697 reporting PCARDBs incurred
losses, which together amounted to 1,524 crore (excluding PACSs).
As at end-March 2010, there were a total of 95,765 rural cooperative
institutions operating in the country. Out of the total number of rural cooperatives,
short-term cooperatives constituted a majority while only 1 per cent of the total
cooperatives operating in the country were long-term in nature. Within the short-
term structure, while StCBs and DCCBs carry on profitable operations, PACS
are incurring huge losses. The financial positions of long-term cooperatives are
weaker than the short-term cooperatives with both SCARDBs and PCARDBs
reporting losses as at end-march 2010. StCBs and DCCBs are heavily dependent
on deposits for their resources whereas borrowings constitute a major part of
total assets in case of PACS, SCARDBs and POCARDBs. The short-term
cooperatives (except PACS) are better placed as compared to their long-term
counterparts in terms of asset quality and recovery performance. The NPA ratio is
higher in the case of long-term cooperatives. Within the short-term structure, the
PACS have the highest NPA ratio, indicating poor asset quality of these grass root
level cooperatives.
Rural Cooperatives—Short-term Structure
The short-term structure of rural cooperatives comprises of StCBs operating as
the apoex institutions in each state, DCCBs operating at the district level and
PACS operatying at a more granular level.
Rural Cooperative Banks—Long-term Structure
The long-term structure of rural cooperatives consists of SCARDBs operating at
the state level and PCARDBs operating at district/block level. As at end-March
2010, the long term co-operative credit structure consisted of 20 SCARDBs and
697 PCARDBs. In those States which do not have the long-term structure, separate
sections of StCBs look after the long-term credit requirements as well.
Self-Instructional
192 Material
Primary Agricultural Credit Societies (PACSs) Regional Rural and
Cooperative Banks
in India
PACSs deal directly with individual farmers, provide short and medium-term credit,
supply agricultural inputs, distribute consumer articles and also arrange for the
marketing of products of its members through a cooperative marketing society. NOTES
PACSs lie at the lowest level of the short-term structure of rural cooperative credit
institutions. A large number of them, however, face severe financial problems
primarily due to erosion of own funds, deposits and low recovery rates. Various
policy initiatives have been taken to improve the financial health of PACSs in
recent years. NABARD has been providing support for developing the
infrastructure in PACSs out of Cooperative Development Fund (CDF). The number
of PACSs stood at 94,647 at end March 2010. The total membership stood at
126 million and the number of borrowing members stood at 48 million at March-
end 2007. For the country as a whole, as at March-end 2007, one PAC on an
average covered seven villages.
The process of implementation of the recommendations of the Task Force
on revival of short-term cooperative credit structure (Chairman being Prof. A
Vaidyanathan) started with the announcement of a package by the Government of
India. Twenty five states have signed MoUs with the Government of India and
NABARD. At end-March 2010, 80,639 PACs completed the required special
audit. Common Accounting System (CAs) and Management Information System
(MIS) were introduced along with several Human Resources Development (HRD)
initiatives. Recapitalization of eligible PACs has been initiated.
Central Cooperative Banks (CCBs)
Central Cooperative Banks form the middle tier of cooperative credit institutions.
CCBs are independent units in as much as the State Cooperative Banks have no
control to control or supervise their affairs. They are of two kinds, viz., ‘pure’ and
‘mixed’. Those banks the membership of which is confined to cooperative
organizations only are included in the ‘pure’ type, while those banks the membership
of which is open to cooperative organizations as well as to individuals are included
in the ‘mixed’ type. The pure type of central banks can be seen in Kerala, Bombay,
Orissa, etc., while the mixed type can be seen in Andhra Pradesh, Assam, Tamil
Nadu, etc. The pure type of banks is based on strict cooperative principles.
However, the mixed type has an advantage over the pure type in so far as they can
draw their funds from the non-agricultural sector too. But by allowing individuals
to hold shares, loan facilities are necessarily extended to them. While in some of
them happen to be middlemen, who may utilize the proceeds of the loans to carry
on their trading operations, then it would be a hard blow on the very basic principle
of cooperation, which strive for the elimination of the middlemen.
The CCBs draw their funds from share capital, deposits, loans from the
State Cooperative Banks and where state banks do not exist from the RBI,
NABARD and commercial banks. Deposits constitute the major component of
Self-Instructional
Material 193
Regional Rural and sources of funds, followed by borrowings. The main function of CCBs is to finance
Cooperative Banks
in India the primary credit societies. In addition, they carry on commercial banking activities
like acceptance of deposits, granting of loans and advances on the security of first
class gilt-edged securities, fixed deposit receipts, gold, bullion, goods and
NOTES documents of title to goods, collection of bills, cheques, etc., safe custody of
valuables and agency services. They also act as ‘balancing centres’, making available
excess funds of one primary to another which is in need of them.
State Cooperative Banks (StCBs)
State Cooperative Banks are at the apex of the three-tier cooperative structure
dispensing mainly short/medium-term credit. A StCB is the principal society in a
state which is registered or deemed to be registered under the Government Societies
Act, 1912, or any other law for the time being in force in India relating to cooperative
societies and the primary object of which is the financing of the other societies in
the state which are registered or deemed to be registered. In addition to such a
principal society in a state or where there is no such principal society in a state, the
state government may declare any one or more cooperative societies carrying on
business in that state to be a State Cooperative Bank (or, banks). StCBs being
the apex institutions in the short-term structure of rural cooperatives, their financial
health has strong influence in the overall financial health of short-term rural
cooperatives. Particularly given the fact that the ground level cooperatives or PACS
incurred huge losses in recent years, StCBs’ ability to provide assistance to PACS
depends on the financial soundness of their own.
As in the case of CCBs, State Cooperative Banks may be ‘pure’ in which
case it will be a federation of CCBs only, or ‘mixed’ in which case it will be a
federation of both CCBs and individual members. The StCBs receive current and
fixed deposits from its constituent banks as well as savings, current and fixed
deposits from the general public and from local boards, other local authorities,
etc. Further, they receive loans from commercial banks and seasonal loans from
the RBI and NABARD. The state governments contribute a certain portion of
their working capital.
The principal function of StCBs is to assist the CCBs and to balance excesses
and deficiencies in the resources of CCBs. This function of the apex bank to act
as a ‘balancing centre’ is important since direct lending is not allowed among the
CCBs. The connection between the StCBs and the primary cooperative societies
is not direct. The CCBs are acting as intermediaries between the StCBs and
primary societies. Of course, in the absence of a CCB, the StCB may act as a
CCB and in that case its connection with primary societies will be direct.
State Cooperative Agriculture and Rural Development Banks
(SCARDBs)
State Cooperative Agriculture and Rural Development Banks constitute the upper-
tier of long-term cooperative credit structure. Though long-term credit cooperatives
Self-Instructional
194 Material
have been allowed to access public deposits under certain conditions, such deposits Regional Rural and
Cooperative Banks
constitute a relatively small proportion of their total liabilities. SCARDBS are mostly in India
dependent on borrowings for on-lending. As on 31 March 2002, as against deposits
of 536 crore, outstanding borrowings of SCARDBS were 14,888 crore. On
the same date, their loans outstanding were 14,000 crore. NOTES
Primary Cooperative Agriculture and Rural Development Banks

(PCARDBs)
Primary Cooperative Agriculture and Rural Development Banks are the lowest
layer of long-term credit cooperatives. As in the case of SCARDBS, PCARDBS
are primarily dependent on borrowings for their lending business. As on 31 March
2002, deposits and borrowings of PCARDBS were at 251 crore and 9,077
crore, respectively, while loans extended by them were of the order of 8,960
crore.
Revitalization of Rural Cooperative Banks
Cooperative credit institutions play a significant role in the deployment of credit
for agriculture and rural sector and account for 45 per cent of the total credit for
the rural sector. These institutions, however, lack professionalism, sound
management system and autonomy in decision-making. Low volume of business/
low resource base, low borrowing membership, high incidence of overdues, and
dual control have adversely affected the health of cooperative credit institutions.
In addition, poor recovery performance has affected the ability of these institutions
to cater to the credit needs of new and non-defaulting members and resulted in
low paid-up share capital. The vital link in the short-term cooperative credit system,
viz., the PACS at the grassroot level is weak. Their size is small and uneconomical
and many of them are dormant. Cooperatives need to augment their resource
base, especially the capital base and pay greater attention to specialization and
diversification of loan business, non-fund business, efficient financial intermediation,
risk management and reduction in NPAs. In recognition of the importance of
cooperative banks in the development process of the rural economy and the need
for its revitalization so as to make them efficient and cost effective instruments for
delivery of rural credit, a task force (Chairman being Shri Jagdish Capoor) was
constituted in April 1999 to study the cooperative credit system and suggest
measures for its strengthening. The terms of reference of the task force were:
(i) to review the functioning of the cooperative credit structure and suggest
measures to rationalise and improve and to make cooperatives as member-
driven and professional business enterprises;
(ii) to study aspects relating to costs, spreads and effectiveness at various tiers
of cooperative credit structure;
(iii) to study the financial performance of the cooperative banks with a view to
improving their financial health so that they can become efficient and cost
effective in the delivery of rural credit and
Self-Instructional
Material 195
Regional Rural and (iv) to review the existing supervisory and regulatory mechanism for cooperative
Cooperative Banks
in India credit institutions and suggest measures for strengthening the arrangements.
Major Recommendations of the Task Force
NOTES The task force submitted its report to the Central Government on 24 July 2000.
The major recommendations of the task force are given below. The implementation
of these recommendations will go a long way towards re-energising the cooperative
sector.
(a) Resource Base
In view of the limited resources of cooperative banks, the task force has emphasised
the need for strengthening the resource base, especially the capital.
(b) Regulation and Control
The report recognized the need for reducing government control over cooperatives,
giving them maximum autonomy and making them ‘member driven’. The report
encouraged state governments to adopt Model Cooperative Societies Act or
dovetail the essential features of the Model Act in their respective State Cooperative
Societies Acts so as to reflect the spirit of democratization and self-reliance
enshrined in the Model Act. Specific action plans need to be prepared to remove
the overlapping of controls and endow functional autonomy and operational freedom
to cooperatives. The duality of control between the state governments on the one
hand and the Reserve bank/NABARD on the other, has adversely affected the
working of cooperative banks. In view of this, the bank-related functions should
be exclusively brought under the purview of the BR Act, 1949 and regulated by
the Reserve Bank.
(c) Professionalism in Cooperative Banks
The cooperative banks should work like professional organizations on sound
managerial systems. The banks’ boards should be professional and accountable
ones. Cooperative banks will have to evolve sound personnel policies encompassing
proper manpower planning and assessment. Banks should have objective and
transparent policies for recruitment of staff.
(d) Business Diversification
The task force emphasized diversification of business products as the prime need
at all levels in the cooperative credit institutions. The diversified avenues may include,
inter alia, housing loans, consumer loans, consortium financing, financing of services
sector, distribution of insurance products, etc. Banks should upgrade their skills
and technology to provide efficient and affordable services. The task force
recommended that the cooperative banks may be permitted to lend up to 10 per
cent of their deposits outstanding as at the end of the previous year for commercial
and technology intensive projects outside the cooperative fold.
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196 Material
(e) Costs, Margin and Funds Management Regional Rural and
Cooperative Banks
in India
In the view of the task force, to ensure viability, cooperative banks will have to
necessarily charge such rates of interest on their loans and advances as will cover
the cost of raising funds, transaction and risk costs, and ensure a positive net rate NOTES
of return. Interest rates offered by cooperative banks on deposits need to be
market driven. No unremunerative business should be thrust upon the PACS and
they should be allowed the discretion to accept or otherwise any non-credit business
such as participation in Public Distribution System. Further, institution-specific
investment policies need to be evolved taking into account, inter alia, composition
of funds, maturity pattern of assets and liabilities, availability of money market
instruments, exposure limits and efficient monitoring and control mechanism.
(f) De-layering in Cooperative Banks
The task force is of the view that continuance of the existing three-tier structure in
the short-term cooperative credit structure in bigger states is generally necessary.
However, measures should be taken to strengthen cooperatives, if necessary, by
voluntary amalgamation/merger based on economies of scale, particularly in areas
where CCBs are unviable and are not in a position to ensure uninterrupted credit
flow to agriculture. Further, the integration of ST and LT structures into a ‘single
window’ organization may be an advantageous proposition. In case a merger is
not possible, both types of institutions may be allowed to handle long-term as well
as short-term credit.
(g) Revitalization Package
The task force expressed an urgent need to initiate measures for the rehabilitation
of potentially viable cooperative banks. Strengthening of base level institutions
would be the key for strengthening the entire structure. The revitalization package
for cooperative banks consists of a four-dimensional programme encompassing
financial, operational, organizational and systemic aspects. The state of the Central
Governments need to take the lead in formulating the rehabilitation package, which
should be unit-specific and not across the board and should be taken-up after
studying its viability and possibility of turnaround in five to seven years. Given the
need to progressively reduce the control of the state governments over the
cooperatives, the financial assistance from the state governments should be by
way of loans and not in the form of equity. The financial burden of rehabilitation
will be shared by members contributing 20 per cent of the costs by mobilising
additional share capital. The balance amount will be equally provided by the Central
and respective state governments by way of interest bearing bonds to be redeemed
in a phased manner. In case of long-term structure, the members’ contribution will
be 10 per cent and balance amount will be shared equally by the Central and
concerned state governments.
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Regional Rural and (h) Cooperative Rehabilitation and Development Fund
Cooperative Banks
in India
A Cooperative Rehabilitation and Development Fund may be set up at NABARD
by an initial contribution of 500 crore from the Central Government for
NOTES implementation of the rehabilitation package in states which fulfil the necessary
pre-conditions for such plans, and also for certain other purposes.
(i) Mutual Assistance Fund
Furthermore, Mutual Assistance Fund may be set up at the state level by
contributions from cooperative institutions in the state for rendering assistance and
providing soft loans to weak primary units to enable them to overcome temporary
difficulties.
(j) Capital Adequacy
The cooperative banks need to move in the direction of strengthening their capital
base and conform to the applicable norms over a period of time.
(k) Recovery Management
The task force suggests that the provisions of the existing DRT may be made
applicable to cooperative banks also where loan size is more than 1 lakh so as to
expedite recovery of chronic overdues. There is a need to evolve compromise/
settlement procedure for closing of long pending overdue loans. The government
should support the cooperative banks in their recovery efforts and desist from
providing across the board interest subsidy and making loan waiver announcements.
(l) Internal Checks, Control and Audit
Lack of appropriate internal control systems like inspections, internal and concurrent
audit and periodic branch visits by the higher tier officials in cooperative banks is
a matter of increasing supervisory concern. This has led to poor MIS in these
banks. These banks should strengthen their internal checks and controls and MIS
so that supervision over these banks could be more effective. Audit of cooperative
institutions should be conducted on a regular basis and the criteria for the audit
classification should be uniform in all the states and be transparent. NABARD
may formulate suitable guidelines for this purpose. The task force is of the view
that audit at all levels may be entrusted to the firms of Chartered Accountants.
(m) Branch Licensing of CCBs
Branch licensing of CCBs needs to be brought under the provisions of the Banking
Regulations Act, 1949.
(n) Transparency and Disclosure Norms
The apex cooperative banks and CCBs may be advised to disclose certain critical
information in their balance sheets like movements in NPAs, provisions, return on
assets, business per employee, profit per employee, etc.
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Supervisory Framework for StCBS and CCBs Regional Rural and
Cooperative Banks
in India
NABARD is the supervisory authority for State Cooperative Banks and Central
Cooperative Banks. NABARD conducts inspection of these institutions under the
provisions of the Banking Regulation Act. In addition, it has also been undertaking NOTES
periodic inspections of state level institutions such as SCARDBS, Apex Weavers’
Societies, Marketing Federations, etc., on a voluntary basis. Such inspections
help in assessing the managerial and financial strength of a bank so as to ensure the
protection of the interests of depositors as well as the bank’s compliance with
statutory regulations.
A Technical Group constituted in 1996 to review the inspection strategy
adopted by NABARD had recommended adoption of CAMELS (Capital
Adequacy, Asset Quality, Management, Earnings, Liquidity, Systems and Controls)
approach for a sharper focus of NABARD’s inspections. In order to have a further
refinement in the inspection strategy, an Expert Committee to Review the Supervisory
Role of NABARD was constituted in January 1998. The committee submitted its
report in April 1998. The major recommendations of the committee are given in
the next section.
The Expert Committee, while advocating the adoption of CAMELS
approach, emphasized the need for adoption of timely and adequate compliance
to inspection reports also as a criterion for judging the performance of banks.
Accordingly, it recommended CAMELSC (Capital Adequacy, Asset Quality,
Management, Earnings, Liquidity, Systems and Controls, and Compliance)
approach for inspections. As per the recommendations, the guidelines for on-site
supervision of cooperative banks were revised in August 1998 since 1998–99. In
order to effect continuous monitoring over banks, a system of off-site surveillance
through a set of returns, both statutory and non-statutory, has been introduced.
Periodic on-site inspections may throw-up the need for in-depth scrutiny of
certain aspects of operations. The Expert Committee has, therefore, recommended
the on-site examinations to be supplemented by additional instruments like systems
study, portfolio inspection, commissioned audit and monitoring visits. Necessary
guidelines have already been developed to undertake such supplementary appraisals.
As regards the recommendation relating to constitution of state level audit
committees to bring about improvement in the quality and content of the audit,
NABARD is pursuing the matter with the state governments. Further, to make the
system of supervision meaningful and effective, NABARD is laying necessary
emphasis on the timely and adequate compliance of the inspection findings by the
institutions concerned.
Another recommendation which has already been implemented is the setting
up of the Board of Supervision in NABARD in November 1999. The Board of
Supervision, set up as an internal committee of the Board of Directors, is entrusted
with, inter alia, the work of framing policy guidelines on matters relating to
supervision and inspection, reviewing the inspection findings on cooperative banks
Self-Instructional
Material 199
Regional Rural and (as also RRBs), and suggesting appropriate measures, identifying the emerging
Cooperative Banks
in India issues in the functioning of these cooperative banks and suggesting measures for
strengthening the supervisory system in NABARD. The board meets frequently
to review the working of banks especially those whose owned funds have been
NOTES eroded due to high level of accumulated losses, provisions for NPAs, etc. With a
view to giving special focus on the cooperative banking structure in individual
states, the Board of Supervision has decided to make a state-wise review of the
working of the cooperative banks for identifying the state’s specific problems and
taking-up the matter with the concerned state government. As per the
recommendations of the Expert Committee, the on-site inspections of StCBs and
SCARDBS are being decentralized in a phased manner.
In one area where most of the cooperative banks are found to be deficient
is in respect of internal control system. Thus, NABARD has laid special emphasis
on strengthening the internal control systems in banks, particularly the inspection
of branches and affiliates and on effecting reconciliation of long pending entries
and balancing of books. The banks have also been advised to introduce/update
operational manuals for improving the internal checks and control systems.
Exhaustive guidelines have been provided by NABARD to the cooperative banks
in proper record maintenance. As internal audit and external audit are interrelated,
bank managements were advised to strengthen their audit systems. To facilitate
this, NABARD has been organizing the conference of Chief Cooperative Audit
Officers of the state governments every year. The conference discusses
arrangements for audit of cooperative credit institutions, measures needed for
improving the audit systems and strategies for ensuring compliance to audit findings.
Supervisory Framework for UCBs
Duality/multiplicity of control of the credit cooperatives comes in the way of effective
regulation and supervision of cooperative banks. The major issue in this context is
the overlapping jurisdiction of the state governments and the RBI. Successive
committees have recommended that there should be clear demarcation of areas
of regulatory responsibilities between the state governments and the RBI. It has
also been recommended that the RBI should regulate and supervise the banking
operations of UCBs. Although the RBI has concurred with such recommendations
and advised the state governments to undertake suitable legislative amendments,
the issue has not been resolved so far. Given the serious implications of the lack of
clear-cut jurisdiction over regulation of cooperative banks, it has been proposed
by the RBI to rationalize this system by establishing a unified regulatory authority
for UCBs with representatives of Centre, states and other interested parties. The
Central Government, in turn, view that the issue be resolved through appropriate
amendments in the Banking Regulation Act rather than through amendment of
respective State Cooperative Societies Acts. Subsequently, RBI has submitted a
draft bill which is under consideration of the government. In any case, if immediate
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200 Material
measures are not taken to remove duality of control, it will be difficult to make the Regional Rural and
Cooperative Banks
supervisory system effective. in India
Inspection
The on-site inspection cycle for scheduled UCBs and weak UCBs is once a year, NOTES
while well managed non-scheduled UCBs are inspected once in three years. All
other UCBs are inspected once in two years. The mechanism for evaluating
performance on the basis of supervisory ratings based on CAMELS parameters
are already in place for commercial banks. A similar rating system has been finalized
for UCBs. Initially, such supervisory ratings would be made applicable to scheduled
UCBs and the same would be extended to other UCBs in a phased manner. This
would be implemented on trial basis for scheduled UCBs from March 2003.
Due to increased number of UCBs, the existing on-site inspection has come
under severe strain. Consequently, a system of continuous off-site supervision has
been put in place through a set of periodical prudential returns for UCBs. The
returns cover asset and liability position, profitability, non-performing assets, details
on credit portfolio and large exposures, etc. During the first phase of implementation
of off-site supervision, scheduled UCBs were advised to submit quarterly returns
commencing with their financial position as on 31 March 2001. It has been observed
that in the past, some UCBs developed serious financial problems soon after they
received licences. Various measures such as close monitoring of the submission of
statutory returns by the banks, special scrutiny of their books of account in case of
default in maintaining CRR/SLR, etc., have been initiated to step-up supervisory
efforts towards such banks.
Financial audit is a key supervisory tool for monitoring implementation of
various prudential norms including accounting, income recognition, asset
classification, provisioning, etc. For UCBs, however, supervision of audit function
falls within the purview of the respective state governments. A committee was set
up in 1995 to review the system and procedures associated with audit of UCBs.
The recommendations of the committee included professionalization of audit,
mandatory concurrent audit of large banks, mandatory setting-up of audit
committees for all UCBs, conduct of statutory audit by chartered accountants
rather than government officials, etc. The RBI has accepted the recommendations
and advised the state governments to implement them. To review the supervisory
framework of UCBs on a regular basis and to recommend suitable steps to
strengthen the existing system, a task force has also been formed headed by an
Executive Director of the RBI.
Check Your Progress

1. Mention the act under which Union Cooperative Banks are registered.
2. What does rural cooperative credit include?
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Material 201
Regional Rural and
Cooperative Banks 10.3 ANSWERS TO CHECK YOUR PROGRESS
in India
QUESTIONS
NOTES 1. Urban cooperative banks are registered under Cooperative Societies Acts
of the respective state governments.
2. Rural cooperative credit institutions include state cooperative banks (StCBs),
district central cooperative banks (DCCBs), primary agricultural credit
societies (PACs), state cooperative agriculture and rural development banks
(SCARDBs) and primary cooperative agriculture and rural development
banks (PCARDBs).
10.4 SUMMARY
 Urban cooperative banks are registered under Cooperative Societies Acts

of the respective state governments.
 The High Power Committee on Urban Cooperative Banks (1999) made a
number of recommendations concerning the regulatory aspects in relation
to UCBs.
 The urban co-operative banking sector comprises a number of institutions
which vary in terms of their size, nature of business and geographic spread.
 Urban cooperative banks form a heterogeneous group in terms of
geographical spread, area of operation, size or even in terms of individual
performance
 Licensing policy for UCBs was revised in August 2000, in consonance with
the recommendations of the High Power Committee.
 NABARD is the supervisory authority for State Cooperative Banks and
Central Cooperative Banks. NABARD conducts inspection of these
institutions under the provisions of the Banking Regulation Act.
10.5 KEY WORDS
 Fund: A fund is a source of money that is allocated for a specific purpose.

 Ivestment: An investment is the purchase of goods that are not consumed
today but are used in the future to create wealth.
 Subsidy: A sum of money granted by the state or a public body to help an
industry or business keep the price of a commodity or service low is called
subsidy.
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Regional Rural and
10.6 SELF ASSESSMENT QUESTIONS AND Cooperative Banks
in India
EXERCISES
Short-Answer Questions NOTES
1. What are urban cooperative banks?

2. Mention the difference between Tier I and Tier II banks.
3. What is the role of high power committees in the working of urban
cooperatives?
4. What are the functions of cooperative banks?
1. What is the Draft Vision Document for urban cooperatives?
2. What are the major recommendations of the high power committee on urban
cooperatives? Discuss.
3. Discuss the working of Central Cooperative banks and State Cooperative
banks?
4. Discuss the role of regional and rural banks.

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Material 203
Place of Private
Sector Banks
UNIT 11 PLACE OF PRIVATE
SECTOR BANKS
NOTES
Structure
11.0 Introduction
11.1 Objectives
11.2 Role and Functions in India
11.4 Summary
11.5 Key Words
11.0 INTRODUCTION
Following the recommendations of the Narasimham Committee (I), there were

recommendations that there shall be no barriers to new banks being set up in the
private sector and in recognition of the need to introduce greater competition with
a view to achieving higher productivity and efficiency of the banking system, the
banking system was liberalized during the early 1990s. This unit discusses the role
and functions of private sector banks in India.
11.1 OBJECTIVES

 Understand the role of private sector banks in India
 Discuss the functions of private sector banks in India
 Learn about the revised guidelines for private sector banks in India
11.2 ROLE AND FUNCTIONS IN INDIA
The Reserve Bank issued a set of guidelines in January 1993 for the entry of new
private sector banks which are as follows:
(i) Formation of Banks—(a) Such a bank shall be registered as a public
limited company under the Companies Act, 1956. (b) The decision of the
Reserve Bank with regard to licensing under the Banking Regulation Act,
1949 (B.R.Act, 1949) and inclusion in the Second Schedule to the Reserve
Bank of India Act, 1934 shall be final. (c) While granting a license, preference
may be given to those banks the headquarters of which are proposed to be
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204 Material
located in a centre which does not have the headquarters of any other bank. Place of Private
Sector Banks
(d) Voting rights of an individual shareholder shall be governed by the ceiling
of one per cent (since raised to 10 per cent in February 1994). However,
exception may be granted under Section 53 of the said Act to public financial
institutions. (e) The new bank shall not be allowed to have as a director any NOTES
person who is a director of any other banking company and not more than
three directors from companies which among themselves are entitled to
exercise voting rights in excess of 20 per cent of the total voting rights of all
the shareholders of the banking company as laid down in the B.R.Act,
1949. (f) The bank will be governed by the provisions of the Reserve Bank
of India Act, 1934, the B.R.Act, 1949 and other relevant statutes. It would
be subject to the directives, instructions, guidelines and advices given by
the Reserve Bank. It would be expected to concentrate on core banking
activities initially.
(ii) Capital—(a) The minimum paid-up capital for such a bank shall be 100
crore and the promoters’ contribution shall be 25 per cent or 20 per cent in
case the capital exceeds 100 crore. NRI participation in the primary equity
of a new bank shall be to the extent of 40 per cent. In the case of a foreign
company or foreign finance company as a technical collaborator or a co-
promoter, equity participation shall be restricted to 20 per cent.
(b) The shares of the bank should be listed on stock exchanges. (c) A new
bank shall be subject to prudential norms in respect of banking operations,
accounting and other policies, norms for income recognition, asset
classification and provisioning as well as capital adequacy of eight per cent
of the risk weighted assets which will be applicable to such new bank from
the beginning so also will be single borrower and group exposure limits.
(iii) Operations—(a) The bank shall have to observe priority sector lending
targets as applicable to other domestic banks. However, some modifications
in the composition of the priority sector lending may be considered by the
Reserve Bank for an initial period of three years. (b) Such a bank will have
to comply with Reserve Bank instructions in respect of export credit and
may be issued an authorized dealer’s licence when applied for. (c) The new
bank shall not be allowed to set up a subsidiary or mutual fund for at least
three years after its establishment. (d) The holdings of such a bank in the
equity of other companies shall be governed by the existing provisions
applicable to other banks, i.e., (i) 30 per cent of the bank’s or the investee
company’s capital funds, whichever is less, and (ii) 1.5 per cent of the bank’s
incremental deposits during a year. The aggregate of such investments in
other companies shall not exceed 20 per cent of the bank’s own paid-up
capital and reserves. (e) Such a bank shall have to lay down its loan policy
within the overall policy guidelines of the Reserve Bank and shall specifically
provide prudential norms covering related party transactions. (f) Such other
conditions as the Reserve Bank may prescribe from time to time.
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Material 205
Place of Private (iv) Opening of Branches—Branch licensing shall be governed by the existing
Sector Banks
policy whereby banks are free to open branches at various centres including
urban/ metropolitan centres without the prior approval of the Reserve Bank
once they satisfy the capital adequacy and prudential accounting norms.
NOTES However, a new bank will be required to open rural and semi urban branches
also, as may be laid down by the Reserve Bank.
Revised Guidelines
Following the recommendations of the working group to review the licensing policy
for setting-up of new private sector banks, in consultation with the Reserve Bank,
guidelines were issued in January 2001 for entry of new banks in the private
sector. The guidelines retained certain existing conditions on the entry of new
banks such as promoters’ capital share at 40 per cent, opening of new branches,
etc. The proposed bank needs to observe the prescribed targets in respect of
priority sector lending (40 per cent of net bank credit) as applicable to other
domestic banks. The major changes in the revised guidelines are:
(i) The minimum paid-up capital for a new bank should be 200 crore, which
shall be increased to 300 crore in subsequent three years after
commencement of business.
(ii) The guidelines enable a non-banking financial company (NBFC) to convert
into a commercial bank, if it satisfies the prescribed criteria of: a) minimum
net worth of 200 crore; b) a credit rating of not less than AAA (or its
equivalent) in the previous year; c) capital adequacy of not less than 12 per
cent; d) net non-performing assets not more than 5 per cent.
(iii) A large industrial house should not promote any new bank. Individual
companies, directly or indirectly connected with large industrial houses may,
however, be permitted to participate in the equity of a new private sector
bank up to a maximum of 10 per cent, but would not have controlling
interest in the bank. The bank shall not extend any credit facilities to the
promoters and companies investing up to 10 per cent of the equity.
(iv) Preference would be given to promoters with expertise of financing priority
areas and in setting-up banks specializing in the financing of rural and agro-
based industries.
The guidelines also prescribed 31 March 2001 as the last date for receipt
of applications. At the first stage, the applications were screened by the Reserve
Bank to ensure prima facie eligibility of the applicants. Thereafter, the applications
were referred to a high level advisory committee, which submitted its
recommendations to the Reserve Bank on 29 June 2001.
During the brief period of their existence, which started operations in April
1995, the performance of the new private sector has been impressive. It may be
noted in this connection that they have the inherent advantage of strong capital
base, lean and specialized manpower, customer orientation, control over operating
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expenses, access to latest technology and innovative services. Another important Place of Private
Sector Banks
advantage which they have is that they are not straddled with non-performing
assets which a chronic problem for the older banks as a result of accumulating
these over the years.
NOTES
Check Your Progress
1. What did the Narasimham Committee recommend?
2. When did the Reserve Bank of India issue a ser of giudelines for the entry
of new private sector banks?

QUESTIONS
1. Narasimham Committee recommended that there shall be no barriers to

new banks being set up in the private sector.
2. The Reserve Bank issued a set of guidelines in January 1993 for the entry
of new private sector banks.
11.4 SUMMARY
 Following the recommendations of the Narasimham Committee (I), there

were recommendations that there shall be no barriers to new banks being
set up in the private sector.
 The decision of the Reserve Bank with regard to licensing under the Banking
Regulation Act, 1949 (B.R.Act, 1949) and inclusion in the Second Schedule
to the Reserve Bank of India Act, 1934 shall be final.
 The minimum paid-up capital for such a bank shall be 100 crore and the
promoters’ contribution shall be 25 per cent or 20 per cent in case the
capital exceeds 100 crore.
 The bank shall have to observe priority sector lending targets as applicable
to other domestic banks.
 Following the recommendations of the working group to review the licensing
policy for setting-up of new private sector banks, in consultation with the
Reserve Bank, guidelines were issued in January 2001 for entry of new
banks in the private sector.
 The guidelines also prescribed 31 March 2001 as the last date for receipt
of applications.
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Material 207
Place of Private
Sector Banks 11.5 KEY WORDS
 Operations: The action of functioning or the fact of being active or in effect.

NOTES  Capital: Capital refers to wealth in the form of money or other assets
owned by a person or organization or available for a purpose such as starting
a company or investing.
 Fund: A fund refers to a sum of money saved or made available for a
particular purpose.

EXERCISES
1. What is the role of private sector banks in India?
2. Mention any two recommendations of the new guidelines issued by the
Reserve Bank of India in January 1993 for the entry of new private sector
banks.
3. How have private sector banks contributed to banking sector in India?
1. What are the new guidelines issued by the Reserve Bank of India in January
1993 for the entry of new private sector banks?
2. What are the major recommendations of the new guidelines issued by the
Reserve Bank of India in January 2001 for the entry of new private sector
banks?
3. What are the major functions of private sector banks in India? Discuss.

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Bankers as Borrowers
BLOCK - IV
BANKER AND CUSTOMER SYSTEM
NOTES
UNIT 12 BANKERS AS BORROWERS
Structure
12.0 Introduction
12.1 Objectives
12.2 Precautions to be taken before Opening Accounts
12.3 Significance of Fixed Deposit Receipts
12.5 Summary
12.6 Key Words
12.0 INTRODUCTION
The modern banking requires that a constituent should either be known to the
banker or should be properly introduced. The bank owed a duty to make enquiries
directed to discover whether a new constituent might use the account for any
fraudulent purposes. The underlying object of the bank insisting on producing
reliable reference is only to find out, if possible, whether the new constituent is a
genuine party or an impersonator or a fraudulent rogue … (however) the burden
of establishing good faith and absence of negligence is on the defendant. The bank
has to establish that they acted without negligence not only in the receipt of the
payment of the cheque amount but even earlier at the time of opening the account.
This unit discusses the precautions to be taken before opening accounts
and discusses the significance of fixed deposit receipts.
12.1 OBJECTIVES

 Understand the precautions to be taken before opening accounts
 Discuss the significance of fixed deposits
 Know about the KYC norms
 Learn about the benefits of other deposits
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12.2 PRECAUTIONS TO BE TAKEN BEFORE
OPENING ACCOUNTS
NOTES Before opening an account, the banker should obtain references from respectable
parties as to the proposed customer’s integrity and respectability. By allowing a
person to open an account without satisfactory reference, the banker would be
inviting unpleasant consequences. In the first place, by obtaining possession of a
cheque book, a dishonest person may use it for nefarious purposes. Secondly, he
may happen to be undischarged bankrupt in which case the banker would be
facing serious consequences. Thirdly, the banker may inadvertently allow an
overdraft, which can be realized only if the customer is a solvent party. Fourthly,
omission to make enquiries regarding a customer before opening an account in
that person’s name is likely to make the banker guilty of negligence. In this
connection, the observations made by Justice Bailhache in Ladbroke vs Todd are
of considerable importance. According to these observations, the bank acted
negligently, for they did not make ordinary enquiries which ordinary, reasonable
people should make in opening an account. It is true that in Bapulal Premchand vs
Nath Bank Ltd, it was held by Justice Chagla that it was not obligatory upon a
bank to make enquiries as to the respectability of a customer in order to avail itself
of the protection given under Section 131 of the Negotiable Instruments Act.
However, in the more recent case of Union of India vs National Overseas and
Grindlays Bank (1978), the Court observed:
In short, the safer course for the banker would be to obtain references as to
the respectability and integrity of a proposed customer before opening an account.
As a matter of fact, it is customary for the banks in India to insist on the introduction
by an existing customer of the branch before opening a new account. They also
insist on the Permanent Account Number (PAN) supplied by the Income Tax
Department, wherever applicable, and two copies of the passport size photographs
of the new customer.
KYC (Know Your Customer) Norms
A brief mention on the KYC norms may not be out of place in this connection.
Restricting money laundering and terrorist financing was the main objective of
KYC norms when it was introduced during the late 1990s in the USA. Following
the USA Reserve Bank of India directed all banks to implement KYC guidelines
for all new bank accounts in 2002. The Bank directed all banks to put in place a
policy framework to know their customers before opening any account. This
involved verifying customers’ identity and address by requiring them to furnish
documents which are accepted as relevant proof. Proof of identity and proof of
residence are the mandatory requirements required under KYC norms. Passport,
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210 Material
Voters ID Card, PAN Card and driving license are accepted as proof of identity Bankers as Borrowers
while proof of residence can be a ration card, an electricity/telephone bill or a

letter from the employer or any recognised public authority certifying the address.
Verification by an existing account holder is also required in some cases. While the
standard documents which are accepted as proof of identity and proof of residence NOTES
are the same for all banks, some deviations are permitted which differ from bank
to bank.
All documents shall be checked against bank’s requirements in order to
ascertain whether they match before initiating an account opening process.
After satisfying himself as to the respectability and integrity of the customer,
the banker must obtain his/her specimen signature. This should be kept in such a
manner as to facilitate quick references.
The customer’s full name, address and occupation should be written above
his account in the ledger. If the customer is allowed to overdraw, particulars regarding
the same should also be recorded. In the case of joint accounts or partnerships or
limited companies, etc., the name of the person/persons authorized to operate on
the account should be clearly stated.
The banker should get from his customer a mandate, if the customer intends
to operate on his account by another person. The mandate should specify the
power delegated to the mandatory. It should be noted here that an authority to
draw and endorse cheques does not imply the authority to overdraw the account.
Specimen signature/s of the person/s authorized to operate on the account should
also be given in the mandate. These particulars should be entered on the ledger.
12.3 SIGNIFICANCE OF FIXED DEPOSIT

RECEIPTS
In addition to accepting money on current/savings bank accounts, bankers receive

money on deposit accounts undertaking to repay the amounts on the expiry of a
specified period, or subject to a notice. Bankers generally prefer deposits which
are repayable after the expiry of a specified period. Such deposits are known as
‘fixed deposits’.
When a person deposits money with the banker on a fixed deposit, a ‘Deposit
Receipt’ is given to him by way of an acknowledgment of the amount deposited.
This document is usually marked ‘not negotiable’ which means that it can not be
transferred by mere endorsement and delivery. It was held in Evans vs National
Provincial Bank of England that payment to a person wrongfully dealing with even
a signed deposit receipt was no discharge to the bank, unless the depositor was
stopped by his conduct from disputing such payment.
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Bankers as Borrowers However, the deposit receipt can be assigned provided due notice of
assignment is given to the banker. But it may be noted here that the banker would
be entitled to recover from the deposit amount any money owing to him from the
depositor at the time of the receipt of such a notice.
NOTES
In some cases, the banker may make the signing of the deposit receipt a
condition precedent to the withdrawal of money. In such cases, it is necessary to
produce the deposit receipt duly signed at the time of withdrawal. Nevertheless,
the banker can not refuse payment in the case of loss of deposit receipt. He can
pay the amount safely after obtaining an ordinary indemnity from the customer. It
may be noted here that the deposit receipt not being a negotiable instrument, any
holder other than the customer will not get a valid title.
A deposit receipt has been held to be a good subject of donation mortis
causa (i.e., a gift made in contemplation of death and to take effect only in the
event of death).
A depositor is not legally entitled to draw cheques against fixed deposits.
But in the case of deposit accounts repayable on demand, there is a conflict of
judicial opinions. In Hopkins vs Abbot, it was held that cheques could be drawn
against deposit accounts repayable on demand. On the other hand, according to
Dr H.L. Hart and Sir John Paget, a depositor is probably not entitled to draw
cheques against deposit accounts repayable on demand. Some banks have a cheque
form printed at the back of the deposit receipt. This, however, does not change
the nature of the deposit account.
A fixed deposit is attachable by a garnishee order as the order attaches
funds due or accruing due.
In the case of insolvency of a depositor, the amount should go to the Official
Assignee. In the case of the death of the depositor, the amount should go to his
personal representatives.
Fixed deposit accounts may be opened in the name of minors and they can
give a valid discharge for the deposit amount repaid to them.
Fixed deposit accounts may be opened in the name of joint parties. Here,
all the parties should combine in withdrawal. In the case of death of one or more
of the parties, the property passes on to the survivor/s whom the banker can
safely pay. When the deposit is in the joint names of husband and wife, as mentioned
earlier, this rule does not apply. On the death of the husband, the property does
not pass on to the widow unless it can be proved that the husband opened the
account with the deliberate intention of making a provision for his wife in case of
his untimely death. In Nagarajamma vs State Bank of India, it was held that a
fixed deposit in the joint names of a husband and wife payable to either or survivor
would not, on the death of the husband, constitute a gift by the husband to his
wife. The decision was followed in Guru Datta vs Ram Datta. If, however, the
wife dies first, in the absence of any express instruction to the contrary, the property
passes on to the husband.
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Deposit receipts given by bankers are exempted from stamp duty. Bankers as Borrowers
In the case of a fixed deposit account, the law of limitation begins to run
from the expiry of the fixed period. If the account is a deposit account repayable
after the expiry of a specified period’s notice of withdrawal, the law of limitation
NOTES
begins to operate immediately after the money is due to be repaid. If the account
is a deposit account repayable on demand, the law begins to operate from the
date when a demand for repayment has been made by the depositor.
Check Your Progress

1. What was the main objective of KYC norms when it was introduced during
the late 1990s in the USA?
2. What are Fixed Deposits?

QUESTIONS
1. Restricting money laundering and terrorist financing was the main objective
of KYC norms when it was introduced during the late 1990s in the USA.
2. Bankers generally prefer deposits which are repayable after the expiry of a
specified period. Such deposits are known as ‘fixed deposits’.
12.5 SUMMARY
 Before opening an account, the banker should obtain references from

respectable parties as to the proposed customer’s integrity and respectability.
 By allowing a person to open an account without satisfactory reference,
the banker would be inviting unpleasant consequences. In the first place, by
obtaining possession of a cheque book, a dishonest person may use it for
nefarious purposes.
 The modern banking requires that a constituent should either be known to
the banker or should be properly introduced.
 A brief mention on the KYC norms may not be out of place in this connection.
Restricting money laundering and terrorist financing was the main objective
of KYC norms when it was introduced during the late 1990s in the USA.
 All documents shall be checked against bank’s requirements in order to
ascertain whether they match before initiating an account opening process.
 The customer’s full name, address and occupation should be written above
his account in the ledger.
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Bankers as Borrowers  In addition to accepting money on current/savings bank accounts, bankers
receive money on deposit accounts undertaking to repay the amounts on
the expiry of a specified period, or subject to a notice.
 Bankers generally prefer deposits which are repayable after the expiry of a
NOTES
specified period. Such deposits are known as ‘fixed deposits’.
 When a person deposits money with the banker on a fixed deposit, a
‘Deposit Receipt’ is given to him by way of an acknowledgment of the
amount deposited.
 In the case of a fixed deposit account, the law of limitation begins to run
from the expiry of the fixed period.
12.6 KEY WORDS
 Fixed Deposit: A fixed deposit (FD) is a financial instrument provided by

banks or NBFCs which provides investors a higher rate of interest than a
regular savings account, until the given maturity date
 Ledger: Ledger refers to a book or other collection of financial accounts.
 Nominee: Nominee refers to a person or company, not the owner, in whose
name a stock, bond, or company is registered.

EXERCISES
1. What are the precautions to be taken before opening a bank account?
2. Why is it important to insist on the introduction by an existing customer of
the branch before opening a new account in India?
1. ‘The modern banking requires that a constituent should either be known to
the banker or should be properly introduced.’ Comment on the statement
with reference to the text.
2. What are the Know Your Customer (KYC) norms of a bank?
3. What is the significance of Fixed Deposits?
4. What is the procedure of applying for a Fixed Deposit in a bank?
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Goddard, John and Wilson O.S. John. 2016. Banking: A Very Short Introduction. NOTES
Delhi.
Self-Instructional
Material 215
Banker and Customer:
Relationship
UNIT 13 BANKER AND CUSTOMER:
RELATIONSHIP
NOTES
Structure
13.0 Introduction
13.1 Objectives
13.2 Definitions of the Terms Banker and Customer
13.3 Relationship, Functions, Subsidiary and Agency Services
13.5 Summary
13.6 Key Words
13.0 INTRODUCTION
Under Section 5(1) of the Banking Regulation Act, 1949, a banking company is
defined as ‘any company which transacts the business of “banking”’. Under Section
5 (1) (b) ‘banking’—means the accepting for the purpose of lending or investment,
of deposits of money from the public, repayable on demand or otherwise, and
withdrawable by cheque, draft, order or otherwise.
13.1 OBJECTIVES

 Understand the definition of banker and customer
 Discuss the relationship between banker and customer
 Learn about the agency services
13.2 DEFINITIONS OF THE TERMS BANKER

AND CUSTOMER
Let us understand the definitions of the terms ‘banker’ and ‘customer’.

The Banker
There has been much controversy regarding the definition of the term ‘banker.’
According to Macleod:
The essential business of a ‘Banker’ is to buy money and debts, by creating
other debts. A banker is therefore essentially a dealer in debts, or credit.
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But this definition is not considered a satisfactory one since it does not Banker and Customer:
Relationship
make any distinction between a banker and a moneylender. A moneylender is also
a dealer in credit. He lends money on the credit of the borrowers or on their
securities. A better definition is that of Dr H.L. Hart. According to him:
NOTES
A banker or a bank is a person or a company carrying on the business of
receiving moneys, and collecting drafts, for customers subject to the obligation of
honouring cheques drawn upon them from time to time by the customers to the
extent of the amounts available on their current accounts.
According to this definition, the essential function of a banker is the
acceptance of deposits of funds withdrawable on demand. Sir John Paget states
that no one can be a banker who does not take deposit accounts, take current
accounts, issue and pay cheques, crossed and uncrossed, for his customers. He
further adds that if the banking business carried on by any person is subsidiary to
some other business, he can not be regarded as a banker.
Section 3 of the Negotiable Instruments Act, 1881 corresponding with Section
2 of the Bills of Exchange Act 1882, states that the term ‘banker’ includes persons
or a corporation or a company acting as bankers. But this definition is not at all a
satisfactory one because the Act does not state as to who can act as bankers.
The Customer
The term ‘customer’ also presents some difficulty in the matter of definition. There
is no statutory definition of the term either in India or in England. However, the
legal decisions on the matter throw some light on the meaning of the term. Thus, in
Great Western Railway Company vs London and County Banking Company, a
customer was defined as a person who has some sort of an account, either deposit
or current account, or some similar relation with a banker. It implies that any
person or corporate body may become a customer by opening a deposit account
or current account, or by negotiating an advance on current or loan account.
According to Sir John Paget, to constitute a customer there must be some
recognizable course or habit of dealing in the nature of regular banking business.
As far as the condition that the transaction should be in the nature of regular banking
business is concerned, there is unanimity. A casual transaction like the encashment
of a cheque cannot be considered to constitute a person as a customer of a bank.
But it is difficult to reconcile with the idea of Sir John Paget when he states that
there must be some recognizable course or habit of dealing in order to constitute a
person as a customer of a bank. According to this view, a single transaction will
not constitute a customer.
A more acceptable view is expressed in Ladbroke vs Todd. According to
the Judge:
‘The relation of banker and customer begins as soon as the first cheque is
paid in and accepted for collection. It is not necessary that the person should have
drawn on any money or even that he should be in a position to draw any money’.
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Material 217
Banker and Customer: Therefore, neither the number of transactions nor the period during which
Relationship
business has been conducted between the parties is material in determining whether
or not a person is a customer. The same view was expressed in the case of
Commissioners of Taxation vs English, Scottish and Australian Bank Ltd. The
NOTES Judge observed:
‘The word ‘customer’ signifies a relationship in which duration is not of
essence. A person whose money has been accepted by the bank on the footing
that they undertake to honour cheques up to the amount standing to his credit is a
customer of the bank in the sense of the statute irrespective of whether his connection
is of long or short standing. The contrast is not between a habitual and a newcomer,
but between a person for whom the bank performs a casual service, e.g., cashing
a cheque for a person introduced by one of their customers, and a person who
has an account of his own at the bank’.
To sum up, the mere opening of an account will constitute a person a
customer of a bank, irrespective of whether his connection is of long or short
standing.
Check Your Progress

1. Define banker.
2. What is the essential business of a banker?
13.3 RELATIONSHIP, FUNCTIONS, SUBSIDIARY

AND AGENCY SERVICES
The true relationship between a banker and a customer is that of a debtor and a
creditor. The banker, when he receives money from a customer, does not hold the
money in a fiduciary capacity. Money left with him is at his disposal, subject to the
obligation to honour cheques of the customer up to the amount of any credit
balance in his account or up to the limit of any overdraft which the banker has
agreed to allow. The observations made in Foley vs Hill bring out clearly the
relationship between the banker and the customer. According to the Judge:
‘Money when paid into a bank ceases altogether to be the money of the
principal; it is then the money of the banker, who is bound to return an equivalent
amount by paying a similar sum to the depositor when he is asked for it. The
money paid into the bank is money known by the principal to be placed there for
the purpose of being under the control of the banker; it is then the banker’s money;
he is known to deal with it as his own, he makes what profit he can, which profit
he retains to himself; paying back only the principal, according to the custom of
the bankers in some places, or the principal and a small rate of interest, according
to the custom of bankers in other places. That being established to be the relative
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situations of banker and customer, the banker is not an agent or factor, but he is a Banker and Customer:
Relationship
debtor.’
A Debt By a Banker vis-à-vis an Ordinary Commercial Debt
A debt due by a banker differs from an ordinary commercial debt in one important NOTES
respect, namely that it is not due unless demanded. In the case of an ordinary
commercial debt, a request by the creditor for payment is unnecessary. In the
Jochimson case, it was held that, it is necessarily a term of such contract that the
bank is not liable to pay the customer the full amount of the balance until he demands
payment from the bank at the branch at which the account is kept.
Law of Limitation and a Debt by a Banker
Based on the decision in the Joachimson case, the limitation period, in the case of
a current or savings bank account, does not begin to run until the customer has
made a demand for repayment which has not been complied with by the banker
irrespective of whether or not interest has been credited to the account.
In the case of deposit accounts repayable on demand, the law of limitation
does not begin to run until demand has been made for repayment. It has been held
in the Jammu and Kashmir Bank Ltd vs Chandra Prakash that as far as money of
a customer in the hands of a banker payable on demand is concerned, the period
of limitation would run from the date of demand for repayment and not from the
date of refusal. In the case of deposit accounts subject to notice, the law does not
begin to run until the expiry of the stipulated notice of withdrawal given by the
customer.
In the case of a fixed deposit, the law of limitation begins to run from the
date at which the depositor is entitled to be repaid. It should be remembered here
that the law does not apply so long as interest is being paid on it or so long as the
deposit receipt is renewed. If it is a condition precedent to the withdrawal of
money that the receipt must be returned to the banker, the law will run only from
the date on which the receipt is produced.
Cases where the Banker is a Trustee and an Agent
Under certain circumstances, bankers enter into fiduciary relations with their
customers. For instance, when a banker receives valuables for safe custody he
acts as a trustee. The property in them does not pass on to the banker. Again,
when he buys or sells securities on behalf of his customer he acts as an agent.
Special Features of the Relationship
Appropriation of Payments
When money is paid in by the customer, or when the banker receives money from
third parties for the credit of the customer, the customer has a right to say that it
should be placed to a particular account, or should be applied in payment of a
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Banker and Customer: particular debt or in meeting certain cheques or bills. The banker is bound to
Relationship
appropriate it accordingly, irrespective of the state of accounts between them. But
if the customer does not make any specific appropriation, the banker can
appropriate, and apply the payment even to a statute-barred debt. When the
NOTES method of appropriation is communicated to the customer, it becomes irrevocable.
In case there is a current account, and neither the banker nor the customer
makes any specific appropriation, then any successive payments will be
appropriated in accordance with the Rule in Clayton’s Case. According to this
rule, it is the first sum paid in that is first paid out. Thus, it is the first item on the
debit side that is discharged or reduced by the first item on the credit side. It
should be noted that the rule applies only to a current or running account.
Banker’s Right of Set-off
As far as the banker’s right of set-off is concerned, there is a conflict of judicial
opinions. In Garnett vs Mckervan, it was held that , in the absence of a special
agreement to the contrary, a banker might set-off a customer’s credit balance
against a debt due to him from the customer and that there was no legal obligation
on a bank to give notice to a customer about its intention to combine accounts.
But in Greenhalgh and Sons vs Union Bank of Manchester, the Judge observed:
‘If the banker agrees with his customer to open two accounts or more; he
has not in my opinion, without the assent of the customer, any right to move either
assets or liabilities from one account to the other; the very basis of his agreement
with his customer is that the two accounts shall be kept separate.’
Again, in Jinda Ram vs Central Bank of India Ltd, it was held that where
there are two separate partnership firms and these firms have two distinct and
separate accounts, the bank is entitled to appropriate monies belonging to one of
the firms for the repayment of an overdraft of another firm. The Court observed
that although two separate firms were involved they were not separate legal entities.
In view of these conflicting judicial opinions, the banker can be on the safer
side by taking an agreement from the customer authorizing him to combine the
accounts at any time without notice and to return cheques which, as a result of his
having taken such an action, would overdraw the combined account.
However, in such cases as the death or bankruptcy of the customer, the
banker can exercise the right of set-off without notice even in the absence of an
agreement, in order to ascertain the net amount owing to him.
At the same time, it may be noted that the right of set-off cannot be exercised
by the banker if he has made some agreement, express or implied, to keep the
accounts separate. This has been laid down in Halesowen Presswork and
Assemblies Ltd, vs Westminster Bank Ltd.
Another point to be noted in this connection is that the banker cannot exercise
his right of set-off if the accounts are not in the same right. For instance, the
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banker cannot set-off the credit balance on a partner’s account against a debt due Banker and Customer:
Relationship
on the partnership firm’s account and vice versa.
Further, the banker cannot combine a trust account with the personal account
of the customer.
NOTES
Again, the right of set-off applies only to existing debts and not to contingent
liabilities. Thus in Jeffryes vs Agra and Masterman’s Bank Ltd, the Judge observed:
‘You cannot retain a sum of money which is actually due against a sum of
money which is only becoming due at a future date.’
Also, the right of set-off does not apply where the customer has deposited
an amount taking a loan from a third party on condition that the money is repayable
if not used for a particular purpose, the bank having notice of the condition attached
to the loan and where the customer is unable to utilize the loan due to liquidation as
was decided in Quistclose Investments Ltd vs Rolls Razor Ltd and others (in
voluntary liquidation) .
Banker’s Obligation to Honour the Customer’s Cheques
Section 31 of the Negotiable Instruments Act, 1881 imposes a statutory obligation
upon the banker to honour the cheques of his customer drawn against his current
account so long as his balance is sufficient to allow the banker to do so, provided
the cheques are presented within a reasonable time after their ostensible date of
issue. The section runs as follows:
‘The drawee of a cheque having sufficient funds of the drawer in his hands,
properly applicable to the payment of such cheque must pay the cheque when
duly required so to do and in default of such payment must compensate the drawer
for any loss or damage, caused by such default’.
The statutory obligation may be extended by an agreement, express or
implied, to the amount of overdraft agreed upon. But after giving sufficient notice,
a banker can withdraw any overdraft limit already granted. In Mohammed Hussain
vs Chartered Bank, the Court referred to the decision in Rouse vs Bradford Banking
Company. Wherein it was held that it may be that an overdraft does not prevent
the bank who have agreed to give it, from at any time giving notice that it is no
longer to continue and they must be paid their money’. But if the bankers ‘have
agreed to give an overdraft, they cannot refuse to honour cheques, or drafts,
within the limit of that overdraft, which have been drawn and put into circulation
before any notice is given to the customer that the limit is withdrawn. The
circumstances under which a banker is justified in dishonouring his customer’s
cheques are discussed elsewhere.
Before dishonouring a cheque of his customer, the banker must make it
certain that circumstances permit him to do so. Otherwise, he will be liable to pay
damages to the customer for injuring his credit. A businessman can recover
substantial damages without pleading and proving actual damage as was held in
Robin vs Steward. But in the case of a non-trading customer, only nominal damages
Self-Instructional
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Banker and Customer: will be awarded unless the damages are alleged and proved as special damages
Relationship
as was held in Gibbons vs Westminster Bank Ltd. In this connection it may be
mentioned that the wrongful dishonour of a cheque for a small amount usually
constitutes greater damage to the credit of the customer than the dishonour of a
NOTES cheque for a larger amount as was held in Davidson vs Barclays Bank Ltd.
As observed earlier, when computing the customer’s balance, the banker
need only to take into account his credit balance at the branch on which the cheque
is drawn. In Mohammed Hussain vs Chartered Bank, the court observed that
though the bank had the right to combine several accounts of the customer, the
customer had no right to require the bank to combine the different accounts in
determining whether a cheque on an account may be dishonoured. The Court
cited the following passage from Halsbury’s Laws of England.
‘Unless precluded by agreement, express or implied from the course of
business, the bank is entitled to combine different accounts in his own right even
though at different branches of the same bank, and to treat the balance, if any, as
the only amount standing to his credit… . The customer, however, has not the
equivalent right, and cannot utilize a credit balance at one branch for the purpose
of drawing cheques on another branch where he has no account or where his
account is overdrawn.’
In the absence of an express or implied agreement giving the customer a
right to draw cheques against uncleared items, the banker is entitled to return such
cheques with the answer ‘effects not cleared’ as was held in Underwood vs
Barclays Bank Ltd. Here it should be remembered that an implied agreement
would arise from some established course of business. Thus, if the banker has
been following the practice of honouring his customer’s cheques drawn against
uncleared items, he cannot, without reasonable notice, return cheques with the
answer ‘effects not cleared’.
The duty of the banker to honour the cheques of his customer, unless
improperly drawn, does not apply to bills of exchange accepted by the customer
and made payable by the banker. Here also, an implied agreement would arise
from some established course of business.
The liability of a banker for wrongful dishonour of acheque is only to the
drawer and not the payee of the cheque. In Meghaji Malsee Ltd vs P.C. Ommen,
one of the points which arose for consideration was whether the plaintiff company,
which was the holder of the cheque, could hold the drawee bank liable. The Court
referred to Section 31 of the Negotiable Instruments Act which deals with the
liability of the drawee of a cheque and observed that the said section referred to
the liability of the drawee to the drawer and not to the payee of the cheque. The
Court also referred to the following observations of the Supreme Court in Jagjivan
Mavji vs Ranchhoddas Meghaji:
‘There is no provision in the Act that the drawee is as much liable on the
instrument, the only exception being under Section 31 in the case of a drawee of
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a cheque having sufficient funds of the customer in his hands, and even then, the Banker and Customer:
Relationship
liability is only towards the drawer and not the payee. This is elementary law… .’
Banker’s Duty to Maintain Secrecy of the Customer’s Account
Because of the peculiarly private character of the transactions between the banker NOTES
and the customer, the banker should not divulge to third parties the state of the
customer’s account except on reasonable and proper occasions. If the banker
fails in his duty, he will be liable for damages which may be substantial in case the
credit of the customer has suffered serious injury. According to Sir John Paget,
this duty of the banker to maintain secrecy does not end even with the closing of
the customer’s account. Further it has been laid down in Tournier vs National
Provincial Bank of England that this secrecy applies not only to information derived
by the banker from the customer himself or from his account but also to information
concerning the customer’s credit that may come into the banker’s possession in
his capacity as a banker. In the instant case, a customer of the National Provincial
Bank drew a cheque in favour of Tournier who, in turn, endorsed it in favour of a
third party who had an account with another bank. On return of the cheque to the
National Provincial Bank, the manager of the bank enquired as to who the person
to whom the cheque was paid. The manager was told that the person was a book-
maker. Tournier sued against the National Provincial Bank on the ground that the
manager disclosed information that Tournier was a book-maker to outsiders. The
Court held that the disclosure constituted a breach of duty on the part of the
National Provincial Bank to Tournier.
However, the duty to maintain secrecy is not absolute, but qualified. The
following qualifications have been cited as examples by the Judge in the above
quoted Tournier case.
 Where disclosure is under compulsion of law.
 Where there is a duty to the public to disclose.
 Where the interests of the bank require disclosure.
 Where the disclosure is made in accordance with an express or implied
consent of the customer.
In addition to the above qualifications, there is a practice among bankers of
giving opinion to one another concerning the creditworthiness of customers. In
such cases, the banker should confine himself to general statements and should
not disclose the details of the account, unless specifically authorized to do so.
It is also important that the banker should not make statements which may
make him liable for defamation or fraudulent misrepresentation. If the banker makes
any statement knowing it to be false and if any third party suffers a loss for having
relied on the statement, the banker will be held liable to such third party to whom
the information is given.
It may be noted in this connection that till recently it was believed that as far
as a banker’s liability to a third party was concerned, he could not be held liable Self-Instructional
Material 223
Banker and Customer: for any false information given negligently since there was no contractual relationship
Relationship
between the banker and a non-customer. But the decision in Hedley Byrne and
Co. Ltd, vs Heller and Partners Ltd, indicates that action for professional negligence
may arise if financial loss is suffered by third parties through their reliance on the
NOTES professional skill and judgment of persons with whom they are not in contractual
or fiduciary relationship. According to the facts of this case, before entering into a
transaction with A, the plaintiffs sought a reference to A’s standing from A’s bankers.
The bankers provided the reference, stating therein that they accepted no
responsibility for its accuracy. The reference proved to be misleading and the
bankers had been negligent. As a result of the loss suffered by the plaintiffs, they
sued the bankers for negligence. The House of Lords held:
(a) that the bankers could be held liable for negligence contained in a
reference; but
(b) that the disclaimer of liability in the reference exonerated them from
liability on the particular facts of the case.
The banker should decline to give any information in response to enquiries
from an outsider who is not a banker, in the absence of an express authority from
the customer concerned. While declining to give information, care should be taken
to see that he does not state anything which is likely to injure his customer’s credit.
Banker’s Lien
Another feature of the relationship between the banker and the customer is the
banker’s right of lien over such of his customer’s securities as may come into his
possession in the ordinary course of business. A ‘lien’ may be defined as the right
to retain property belonging to a debtor until he has discharged a debt due to the
retainer of the property.
A distinction may be made between a ‘general lien’ and a ‘particular lien’. A
‘particular lien’ confers a right to retain the goods in respect of a particular debt
involved in connection with a particular transaction. A ‘general lien’ confers a right
to retain goods not only in respect of debts incurred in connection with a particular
transaction but also in respect of any general balance arising out of the general
dealing between the two parties.
Banker’s lien is a general lien. It has been held in Brandao vs Barnett that
bankers have a general lien on all securities deposited with them as bankers by a
customer, unless there is an express contract, or circumstances that show an implied
contract, inconsistent with the lien.
Further, in the same judgment, a banker’s lien has been defined as an implied
pledge. An ordinary lien does not imply a power of sale; but a pledge does. But a
banker’s right of sale is generally regarded as extending to only fully negotiable
securities. It is not clear whether the banker’s right of sale extends to securities
which are not fully negotiable. Most cases concerning lien have applied to negotiable
securities and, in the absence of legal decision on the matter, it seems advisable to
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regard a banker’s lien on non-negotiable securities as conferring only a right to Banker and Customer:
Relationship
retain them until his demands have been satisfied.
Section 171 of the Indian Contract Act has specifically conferred upon the
banker the right of general lien. In terms of this section, a banker has a general lien
NOTES
on cash, cheques, bills of exchange and securities deposited with him in his character
of a banker for any money due to him as banker.
Cases where the Banker Cannot Exercise His Right of Lien
1. In the case of securities deposited with the banker for safe custody only, the
banker is acting as a bailee and has no lien over such articles.
2. In the case of funds and securities specifically appropriated, the banker
cannot exercise his right of lien because there is an express contract
inconsistent with the lien as was held in Krishna Kishore Kar vs Uco Bank.
3. A bank has no right of lien in respect of money deposited by a customer or
a credit balance earmarked by the customer for a specific purpose, although
the right of lien applies where the bank has no express or implied notice of
the purpose of the deposit.
4. Right of lien is not exercisable where documents or valuables are left in the
hands of the banker inadvertently. But where the securities are left in the
hands of the banker even after the loan for which the securities were given
as collateral is repaid, right of lien is exercisable over them. By leaving the
securities with the banker, the customer is supposed to have re-deposited
them with the banker as was held by the House of Lords in the case of
London and Globe Finance Corporation. The position was endorsed in
India by the Supreme Court in Syndicate Bank vs Vijay Kumar. In the
instant case, certain fixed deposit receipts held by the bank to cover a
guarantee issued by the bank were allowed to be retained by the bank as
general lien even after the discharge of the guarantee. The decision was
followed in State Bank of India vs Deepak Maviya. The decision by the
National Consumer Disputes Redressal Commission in State Bank of India
vs Jawaharlal was also similar.
5. A general lien cannot arise in respect of property of a customer pledged as
security for a particular debt.
6. The banker cannot exercise his right of lien in respect of property coming
into his hands by mistake, or which is placed in his hands to cover an advance
that is not granted as was held in Lucas vs Dorrien.
7. No lien arises until the due date in respect of an advance of a specific
amount for a definite period.
8. No lien arises in case the credit and liability do not exist in the same right.
Thus, the banker cannot exercise his right of lien over the securities or funds
of a partner in respect of a debt due from the partnership firm.
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Banker and Customer: 9. The banker cannot exercise his right of lien in respect of a separate account
Relationship
maintained by the customer which is known to the banker as a Trust Account.
10. No lien arises over properties on which the customer has no title.
NOTES Banker’s Right to Charge Interest and Commission
A banker is entitled to charge interest on loans, either by express agreement or by
right of custom or usage of trade. He is also allowed to charge compound interest
unless there is an agreement to the contrary.
In the absence of an express agreement, or without due notice, a banker is
not entitled to debit his charges at any other than the customary dates. And if the
banker dishonours his customer’s cheques owing to lack of funds by reason of his
having done so, he may be held liable for unjustifiable dishonour.
The banker is also entitled to charge commission for services rendered to
his customer.
Garnishee Orders
A ‘garnishee order’ is an order of the Court, obtained by the judgment creditor
attaching funds in the hands of a third party who owes judgment creditor money,
warning the third party (the Garnishee) not to release money attached until directed
by the Court to do so. For instance, if A obtains judgment in respect of a debt due
to him from B, A may apply to the Court for a garnishee order attaching funds in
B’s bank account.
Before issuing an absolute garnishee order, a garnishee order nisi is issued
to the banker. In the case of a garnishee order nisi, although the order attaches
funds in the hands of the banker (the garnishee), an opportunity is given to him to
show cause why the funds should not be handed over to the judgment creditor.
On the banker failing to show sufficient cause, the order is made absolute. The
banker should not pay over funds until the order is made absolute as he has no
authority for payment under an order nisi.
When a garnishee order is served on a banker, he should attach all funds
due or accruing due. The term ‘accruing due’ means debts already incurred, but
payable on a future date. It does not include debts not existing at the time the
order is served. In the case of a current or savings bank account, although it might
appear that it is not a debt due until a demand for repayment is made, the garnishee
order itself operates as a demand for repayment sufficient to render money in that
account immediately repayable as was held in the Joachimson Case.
Thus, a current/savings bank account is attachable by a garnishee order. So
also a deposit account repayable on demand is attachable by a garnishee order.
Further, the following kinds of deposits are attachable:
1. A deposit repayable on fixed notice, provided the notice has been given
before the order is received. However, under Section 38 of the
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226 Material
attachable by a garnishee order, notwithstanding any condition as to Banker and Customer:
Relationship
return of the receipt or the absence of a notice.
2. A deposit repayable on a fixed date. In this case it is a debt accruing
due.
NOTES
Therefore, when the banker is served with a garnishee order, he should
stop operations on the accounts of the customer. It must remain dormant until the
order is discharged. Nevertheless, the banker can open a new account and operate
it during the garnishee proceedings. The new account is not attachable by the
garnishee order as it attaches only debts due or accruing due at the date when the
order is served and not future debts. Further, in the case of a limited garnishee
order (where the sum attachable is specified), the banker can transfer any credit
balance to a new account with the consent of the customer, and this new account
can be allowed to be operated freely.
Before paying the amount in accordance with a garnishee order, a banker is
entitled to deduct from the customer’s credit balance all debts due to him at the
date of the order. For this purpose, he can combine all the accounts of his customer.
But he is not entitled to retain moneys against contingent liabilities. Nor is he entitled
to transfer the balance in the current account to a loan account to defeat a garnishee
order.
In England, the Court, by issuing a writ, commands the sheriff to seize the
goods and bring them to the court. In India, the Court levies attachment by issuing
a prohibitory order, which basically restricts or restraints the alienation of the
attached property. Therefore, in England, as soon as the garnishee order is served,
the attaching creditor becomes a secured creditor. But in India, that would not be
so merely on the serving of a garnishee order. However, the position of law in
India would not be unlike that prevailing in England when pursuant to the order of
attachment or by the coercive process, the moneys attached are actually brought
into the Court as was held in Rikhabchand Mohanlal Surana vs the Sholapur
Spinning and Weaving Co. Ltd. In the instant case, the High Court opined that,
although so long as the attachment order is of a prohibitory nature, the creditor
may not have any rights or security in the property. Once the money is brought into
the Court, the attaching creditor is entitled to insist that that money should be
handed over to him in satisfaction of his decree. The High Court agreed with the
statement in Halsbury’s Laws of England that the judgment creditor is entitled to
insist on payment to himself by the garnishee. The High Court observed that the
attaching creditor, having taken steps to obtain payment against the decree, can
not be told that the Court is holding moneys not for him but for the debtor, more so
when the garnishee obtains complete discharge by making payment in the Court.
In the result, the attaching creditor was held to be secured creditor.
Where Funds are not Attached by a Garnishee Order
1. In the case of funds coming into the banker’s hands subsequent to the receipt
of the garnishee order, they are not attached. This is because a garnishee Self-Instructional
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Banker and Customer: order attaches funds due or accruing due as on the date of the garnishee
Relationship
order. It may be noted here that the date of attachment and not the date on
which the application for attachment is made that is material. In other words,
the attachment of the debt due to the judgment debtor is not illegal because
NOTES application for attachment is made before it became due as was held in
Nandikatta Anjana and others vs Bandi Ramakrishna and others. In this
case, it was not disputed that the application for attachment was made
before the debt fell due for payment though the attachment was actually
levied after the debt became due. It was contended that the application
having been made prior to date on which the debt became due, the attachment
order should be deemed to be one in respect of a contingent debt and was,
therefore, bad. The High Court, however, rejected this contention and
observed that the date of attachment and not the date on which the application
for attachment was made that was material. If the debt was due by the date
on which the attachment was effected, there could not be any valid objection
against the same, simply because the application for its attachment was
made before it became due.
2. In the case of a joint account, it is not attached by a garnishee order, provided
the order is issued against only one of the account holders. Here again,
reference may be made to the decision in Nandikatta Anjana and others vs
Bandi Ramakrishna and others mentioned above. It has been held that the
attachment of a debt jointly due to a judgment debtor with another is illegal.
The High Court referred to the decision in Macdonald vs Tacquash Gold
Mines Co., in which a view was taken that a debt, legal or equitable, owing
by a garnishee to a judgment debtor, should not be a debt due to him jointly
with another person. Observing that this view was approved by the Indian
Courts, the High Court referred to the decision in Batcha vs Sulaiman Sahib
in which it was held that under Order 21, Rule 46 of the Civil Procedure
Code, the attachment could be made of a debt due to a judgment debtor
alone and not a debt due to the judgment debtor and another.
3. In the case of a partnership firm’s account, it is not attached by a garnishee
order provided the order is issued against only one of the partners.
4. In the case of an overdrawn account of a customer, the garnishee order will
not attach funds even though the customer has not reached the agreed limit
of overdraft when the order is served.
5. In the case of a garnishee order which does not correctly designate the
judgment debtor and the account which he has with the bank, funds are not
attached.
6. In the case of amounts credited as cash in respect of uncleared items, it is
doubtful whether they are attached by a garnishee order. In Jones vs
Coventry, it was held that they were attached by a garnishee order. However,
in view of a later decision in Underwood vs Barclays Bank, the earlier
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228 Material
decision does not appear to hold good. The later decision recognized the Banker and Customer:
Relationship
banker’s right to return cheques drawn against uncleared items in the absence
of a contract, express or implied, to the contrary. A still more recent decision
in Fern vs Bishop & Co. Ltd and another upheld the decision in Underwood
vs Barclays Bank. In this case, a garnishee order was served on the debtor’s NOTES
bank for an amount of £806. The debtor’s credit balance was £4,998,
including an item of £4,700 representing a cheque paid in for collection but
not collected. The bank, having deducted bank charges due to it, opened a
new account for the £4,700 and left £218 to meet the judgment debt. The
Judge stated that the question was whether at the time the garnishee order
was served, the sum of £4,700 constituted a debt owed by the bank to the
judgment debtor, that is whether the bank was holding the cheque in question
as a holder for value. It was held in Underwood vs Barclays Bank that for
a bank to become a holder for value there had to be a contract between the
banker and the customer, express or implied, that the latter might draw
against cheques which were not cleared. Applying that to the instant case,
there was no evidence of such a contract. As to the burden of proving such
a contract, if there were an express agreement the bank would be under a
duty when served with a garnishee order nisi to disclose the fact to the
judgment creditor. But if such an agreement were to be implied from a
course of conduct, it would be wrong for a banker to offer details of a
customer’s banking transactions to any judgment creditor, who could use
the machinery of discovery under the control of the Court. In the instant
case this had not been done. Thus, the garnishee order was made absolute
in the sum of £218.
7. Until recently it was considered that a garnishee order could not attach a
debt owing in a foreign currency. But the decision in Choice Investments
Ltd, vs Jemnimon : Midland Bank Ltd, indicates that a garnishee order
could attach even a credit balance maintained in a foreign currency. In this
case the question was whether the garnishee order issued against the bank
could attach funds in a US$ Deposit Account maintained by the judgment
debtor in England. The Judge outlined the procedure to be followed as
follows,
‘…as soon as the garnishee order nisi it operates to “freeze” the sum
in the hands of the bank, in this way; the must, as soon as reasonably
practicable, in the ordinary course of business, put a ‘stop order’ in
the requisite amount of US dollars. It should be such a number of
dollars as, if realized at the time of the stop order, would realize the
amount of the sterling judgment—at the buying rate of sterling ruling
at the time of the stop order. The bank should not make a transfer into
sterling at that stage. But, if and when the garnishee order is made
absolute, the bank should exchange that stopped amount from dollars
into sterling so far as is necessary to meet the sterling judgment debt
and pay over that amount to the judgment creditor. But if and so far
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Material 229
Banker and Customer: as the stopped amount (owing to exchange fluctuations) is more than
Relationship
enough to meet the judgment debt, the bank must release the balance
from the stop order and have it available to the customer on demand.
If the stopped amount is, when the garnishee order is made absolute,
NOTES by virtue of exchange fluctuations, insufficient to satisfy the judgment,
remaining funds with the banks are not affected…..’
Banker–Customer Relationship in the context of Bankers
Book Evidence Act

As observed earlier, a banker has to disclose the state of a customer’s account
under an order from a Court of Law. Before the enactment of the Bankers’ Book
Evidence Act, 1891, a banker had to produce the actual books of accounts
whenever he was summoned to do so by any of the parties to the suit. But the
Bankers’ Books Evidence Act provides that, a certified copy of any entry in a
banker’s book shall in all legal proceedings be received as prima facie evidence of
such entry, and of the matters, transactions and accounts therein recorded. In
terms of Section 4 of the Act:
‘A certified copy of any entry in a banker’s book shall in all legal proceedings
be received as prima facie evidence of the existence of such entry, and shall be
admitted as evidence of the matters, transactions and accounts therein recorded
in every case where, and to the same extent as, the original entry itself is now by
law admissible, but not further or otherwise.’
Further, Section 5 of the Act provides that a banker or officer shall not in
any legal proceedings to which the bank is not a party be compellable to produce
any banker’s book the contents of which can be proved under the Act, or to
appear as a witness to prove the matters, transactions and accounts therein
recorded, unless by the order of the Court or a Judge made for a special cause. At
the same time, if the bank is not a party in the action and if the Court is not satisfied
that the certified copies produced are true copies of the accounts maintained by
the bank, it is open to the Court to direct the bank authorities to produce the
original books.
A ‘certified copy’ has been defined by the Act as a copy of any entry in the
books of a bank together with the certificate written at the foot of such copy that
it is the true copy of such entry, that such entry is contained in one of the ordinary
books of the banker, and that such book is still in the custody of the bank. The
term ‘Bankers’ Books’ includes ledgers, day books, cash books, accounts books
and all other books used in the ordinary business of the bank.
A Court or Judge may also give any party to a legal proceeding leave to
inspect and take copies of any entries in a banker’s books. The relevant provision
is contained in Section 6 of the Act in terms of which:
1. On the application of any party to a legal proceeding, the court or Judge
may order that such party be at liberty to inspect and take copies of any
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230 Material
entries in a banker’s books for any of the purposes of such proceeding, Banker and Customer:
Relationship
or may order the bank to prepare and produce, within a time to be
specified in the order, certified copies of all such entries are to be found
in the books of the bank relevant to the matters in issue in such
proceeding, and such further certificate shall be dated and subscribed in NOTES
a manner hereinbefore directed in reference to certified copies.
2. An order under this or the preceding section may be made either with or
without summoning the bank, and shall be served on the bank three
clear days (exclusive of bank holidays) before the same is to be obeyed,
unless the Court or Judge shall otherwise direct.
3. The bank may at any time before the time limited for obedience to any
such order as aforesaid either offer to produce their books at the trial or
give notice of their intention to show cause against such order, and
thereupon the same shall not be enforced without further order.
It may be noted here that although the Court is bestowed with such wide
powers, no Court would grant such an order except on the clearest evidence of its
necessity. It has been held in Satyanarain JhunJhunuwala vs Punjab National Bank
that an application under the Bankers’ Book Evidence Act for an order upon a
bank to supply a certified copy of the entries in respect of one of its customers for
a particular period could not be allowed because it being a third party document,
the same ought not to be allowed to be produced by this process unless very
special circumstances are shown. The Court quoted with approval the observations
in Central Bank of India Ltd vs P D Shamdasani wherein Beaumont, C.J. has said:
‘The Legislature has endowed the Courts with wide powers of ordering
production of documents necessary for the determination of matters before the
Court, and for directing inspection of those documents but it must always be borne
in mind that an order directing a person to produce or give inspection of the books
in a dispute to which he is not a party involves a serious inroad upon his normal
rights as a citizen and the Courts have always set their faces against anything in the
nature of a roving or fishing commission to inspect documents… . If the Courts
were to make orders for inspection of books merely on an allegation that certain
facts are not true, the practice would be open to an unscrupulous person to make
a false charge, possibly against a business rival, and then get inspection of that
business rival’s books.’
It may carefully be noted here that if the bank is a party in the action, it can
be compelled to produce its actual books under sub-poena.
The exemption granted to bankers from producing their books under the
Act in any legal proceeding to which the bank is not a party, however, does not
hold good in case of a police investigation. In terms of the decision in A.F.G. Price
vs Emperor, it is not the intention of the Legislature to exempt banks from the
operation of Section 94 of the Indian Criminal Procedure Code under which an
officer in charge of a police station can, by a written order, call upon a person to
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Material 231
Banker and Customer: produce any documents which the police officer thinks relevant to the investigation
Relationship
he is carrying on. In other words, a police investigation is not a legal proceeding in
the sense in which the term is employed in Section 5 of the Bankers’ Book Evidence
Act on the ground that a police investigation has nothing to do with evidence in its
NOTES legal sense, which is the essence of legal proceeding.
Another important point to be noted here is that a certified copy of an entry
in a banker’s books is only a prima facie evidence, and not a conclusive evidence.
The observations made by the Judge in Chandradhar Goswami and others vs
Gauhati Bank Ltd, are pertinent in this connection. According to these observations,
while the bankers Book Evidence Act recognizes certified copies admissible as
evidence, such admissibility is only to the same extent as the original entry itself
would be admissible by law, not further or otherwise. By reason of Section 34 of
the Evidence Act, the original entries alone would not be sufficient by themselves
to charge any person with liability and so copies produced under Section 4 of the
Bankers’ Book Evidence Act cannot by themselves are sufficient to charge any
person with liability.
Check Your Progress

3. What is the true relationship between a banker and a customer?
4. Define a lien.

QUESTIONS
1. A banker is therefore essentially a dealer in debts, or credit.

2. The essential business of a ‘Banker’ is to buy money and debts, by creating
other debts.
3. The true relationship between a banker and a customer is that of a debtor
and a creditor.
4. A ‘lien’ may be defined as the right to retain property belonging to a debtor
until he has discharged a debt due to the retainer of the property.
13.5 SUMMARY
 The essential business of a ‘Banker’ is to buy money and debts, by creating

other debts. A banker is therefore essentially a dealer in debts, or credit.
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232 Material
 Section 3 of the Negotiable Instruments Act, 1881 corresponding with Banker and Customer:
Relationship
Section 2 of the Bills of Exchange Act 1882, states that the term ‘banker’
includes persons or a corporation or a company acting as bankers.
 The term ‘customer’ also presents some difficulty in the matter of definition.
NOTES
There is no statutory definition of the term either in India or in England.
However, the legal decisions on the matter throw some light on the meaning
of the term.
 The true relationship between a banker and a customer is that of a debtor
and a creditor. The banker, when he receives money from a customer, does
not hold the money in a fiduciary capacity.
 As far as the banker’s right of set-off is concerned, there is a conflict of
judicial opinions.
 The drawee of a cheque having sufficient funds of the drawer in his hands,
properly applicable to the payment of such cheque must pay the cheque
when duly required so to do and in default of such payment must compensate
the drawer for any loss or damage, caused by such default.
 Because of the peculiarly private character of the transactions between the
banker and the customer, the banker should not divulge to third parties the
state of the customer’s account except on reasonable and proper occasions.
 Another feature of the relationship between the banker and the customer is
the banker’s right of lien over such of his customer’s securities as may
come into his possession in the ordinary course of business.
 A ‘lien’ may be defined as the right to retain property belonging to a debtor
until he has discharged a debt due to the retainer of the property.
 A banker is entitled to charge interest on loans, either by express agreement
or by right of custom or usage of trade.
 A ‘garnishee order’ is an order of the Court, obtained by the judgment
creditor attaching funds in the hands of a third party who owes judgment
creditor money, warning the third party (the Garnishee) not to release money
attached until directed by the Court to do so.
13.6 KEY WORDS
 Banker: An individual that is employed by a banking institution and

participates in various financial transactions is called a banker.
 Trustee: A trustee is an individual person or member of a board given
control or powers of administration of property in trust with a legal obligation
to administer it solely for the purposes specified.
 Debt: Debt refers to a sum of money that is owed or due.
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Banker and Customer:
Relationship 13.7 SELF ASSESSMENT QUESTIONS AND
EXERCISES

1. How does a debt due by a banker differs from an ordinary commercial
debt?
2. What do you understand by law of limitation?
3. What are the cases when a banker cannot exercise his right of lein?
4. What are garnishee orders?
1. Who is a banker? Disuss the major functions of a banker.
2. ‘The relation of banker and customer begins as soon as the first cheque is
paid in and accepted for collection.’ Comment on the statement with
reference to the text.
3. Mention the cases in which a banker is a trustee and not an agent.
4. What are the special features of the relationship between a banker and a
customer?

Delhi.
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234 Material
Recent Trends in Indian
UNIT 14 RECENT TRENDS IN Banking System
INDIAN BANKING SYSTEM

NOTES
Structure
14.0 Introduction
14.1 Objectives
14.2 Recent Trends: An Overview
14.4 Summary
14.5 Key Words
14.0 INTRODUCTION
As a rule, banking systems are adapted to the structure and needs of the particular
economy they exist in. Indian economic policy has been founded on the philosophy
of economic growth with social justice. It is against this background that we have
to assess the steps taken by the Indian banking system during the recent past
which marks a significant departure from the beaten track of traditional banking.
14.1 OBJECTIVES

 Understand the recent trends in the Indian banking system
 Discuss the developments in the field of branch banking
 Learn the importance of banking habitat
 Know about money lending
14.2 RECENT TRENDS: AN OVERVIEW
The concept of banking has undergone a dynamic change in keeping with the need
to achieve rapid socio-economic progress although the achievements have not
been without cost and shortcomings.
The most striking feature is its reach. Banks are no longer confined to
metropolitan cities and large towns. The branch network is extensive and these
branches are now spread out into the remote corners of our country. In terms of
the number of branches, Indian banking system is one of the largest, if not the
largest, in the world today. An equally important achievement is the close association
Self-Instructional
Material 235
Recent Trends in Indian of our banks with the country’s developmental efforts. The diversification and
Banking System
development of our economy, and the acceleration of the growth process, are in
no small measure as a result of the critical role which our banks have played in
financing economic activities in various sectors.
NOTES
From Security Orientation to Purpose Orientation
According to traditional banking theory, the creditworthiness of a person is based
on the basis of the tangible assets owned by him. The result is that people who have
money can get more money from the banks. This concept does not fit in the social
concept which enjoins that it is not enough that only people of means are given bank
finance. What is more important is that bank finance should go to make people
creditworthy, through productive efforts on their part, and to turn them into people
of means. Basic to this new concept of banking, a shift in the approach to lending
from security orientation to purpose orientation is necessary. In fact, technical
competence of the borrower, operational flexibility and economic viability of the
project rather than the security which the borrower can offer are gradually becoming
popular among the banking community in evaluating a loan proposal.
The identification of the priority sectors for the purpose of financing by banks
has given a new orientation to the Indian banking system. The measures taken by the
banks in this regard, which are primarily aimed at furthering the welfare of the common
man, have already been highlighted at an earlier point. It may briefly be mentioned
here that the change in the pattern of banks’ business has taken the form of a much
enlarged quantum of credit to the hitherto neglected, or more positively, the new
priority sector. From a mere 307 crore which represented about an eighth of the
total bank credit in December 1966 and 504 crore which represented 15 per cent
of the total bank credit in June 1969, the share of public sector banks in the priority
sector was 1,46,546 crore as at the end of March 2001. As a share of net bank
credit, this constituted 43 per cent. Agricultural credit has risen from under 200
crore in June 1969 to 53,685 crore in March 2001 with its share at 15 per cent.
An important point worth noting here is that this large increase has been reasonably
well distributed as is evident from the fact that the total number of borrowal accounts
from the banking system which stood at 1.64 lakh in June 1969 increased manifold
in the case of agricultural borrowers alone. The overall picture of the priority sectors
is still more impressive. On the side of bank credit, there were barely 4 lakh accounts
in the priority sectors in June 1969. By 2002, the number of such accounts has risen
to nearly 40 million. The importance of the priority sectors in our economy can be
gauged from their contribution to the national income generation, the creation of
employment opportunities and the diffusion of economic power. Prior to social control
and nationalization, the banking system was negligent in its attitude to these sectors.
It was social control and the guidelines of the erstwhile National Credit Council
which brought the first stirrings towards a major meaningful sectoral deployment of
credit in favour of these areas of activity and, as was only to be expected, banks
operated in the margin in the sense that the incremental ratio of the new credit to
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236 Material
these sectors went up sharply. Also, the internationalization of the new philosophy Recent Trends in Indian
Banking System
was quickly reflected in the new orientation given to policies and programmes of the
various banks and innovations introduced by them in their schemes.
Correction of Regional Imbalances: NOTES
Developments in the Field of Branch Banking
The increasing realization of the banking system to fall in line with the socio-economic
objectives necessitated the expansion of the network of branches to the
underbanked areas of the country. In December 1966, there were little under
6,600 branches and by June 1969, this figure reached to about 8,260. Between
June 1969 and end-April 1976, the number of all commercial banks in the country
increased by 12,555, bringing down the average population served per bank office
from 65,000 to 26,000. By June 2002, there were 66,186 branches of commercial
banks. The average population per bank office had come down to 15,000 at the
end of June 2002. Such a pace of expansion has few, if any, parallels in the history
of banking development anywhere in the world. Most of the branch expansion has
occurred in the rural and semi-urban areas, reflecting the concern to achieve a
more balanced spatial distribution of credit, and today there is a bank office in
almost all the 5,000 odd development blocks in the country. As at the end of June
2002, rural branches accounted for 49.1 per cent of all the branches. Thus, the
branch expansion of banks has been aimed at correcting the regional imbalances
in banking development. Branches of a bank are a means, an essential means, to
the end we are seeking, namely, a greater involvement of banks with decentralized
activity. The new branches in the rural areas are expected to increase the flow of
credit to rural occupations in general and agriculture in particular, and to mobilize
the savings generated in the rural sector.
The ‘area approach’ is another method adopted by the banking system to
correct the regional imbalances in development. The ‘Lead Bank Scheme’ is the
main instrument of this aspect of banking policy. The Lead Banks are engaged in
preparing credit plans based on bankable schemes which are expected to assist in
the economic development of the rural areas of the country and to bring about a
more systematic involvement of banks in grassroot level development.
Development of Banking Habit
As a natural corollary to the development in the field of branch banking,
development of banking habits in India during the last few decades has been at an
unparalleled pace. Obviously, the banking system in the country has made a
significant contribution to ensure such progress. Sustained efforts have been made
by banks to induce people to keep a part of their savings as bank deposits, and to
expand and diversify their lending portfolio to cover a considerably large number
of borrowers than ever before. A good measure to the development of banking
habit is provided by the growth in the volume of banking transactions in relation to
Self-Instructional
Material 237
Recent Trends in Indian gross domestic product. In 1969, deposits amounted to 13 per cent of GDP and
Banking System
advances 10 per cent. By 2002, deposits as a proportion of GDP has risen to
around 50 per cent and advances to well above 25 per cent, indicating the extent
to which the banking system has been instrumental in spreading the banking habits
NOTES in the country. An idea of the extent to which the banking system has been able to
spread banking habits in the rural areas is indicated by the fact that the growth of
deposits of rural branches has been much faster than that of total deposits. The
rapid development of banking habits is also evidenced by the considerable increase
in the use of cheques in recent years. Another important parameter which is a
symbolic indicator of the growing banking habits is the growth in bank credit.
Attitudinal Change on the Part of Bankers
A welcome change in the philosophy and techniques, particularly in the field of
bank lending, is taking place. This relates to the attitudes on the part of banks. As
observed by the former governor of the Reserve Bank of India:
‘Commensurate with the growth of branch banking in the rural areas and
the larger involvement of banks with agricultural and small industrial clients, we
have had an attitudinal change on the part of bankers, a change symbolized by
banking going retail instead of its erstwhile wholesale character and the system
itself shedding its elitist image to become more truly an operation for the masses
rather than for the classes. Social control sought to break the link between those
who owned the banks and the satisfaction of their credit needs. It was realized
that a system where the grant of credit was a matter of privilege had to be replaced
by one where the requirements of credit were assessed on the basis of genuine
production need and on impersonal norms… .’
Emergence of Retail Banking
During the recent past, the retail character of banking operations has become
more predominant, especially among the new private sector banks. Retail banking
or mobilizing deposits from individuals and providing loan facilities to them in the
form of home loans, auto loans, credit cards, etc., is becoming popular. This used
to be considered by the banks as a tough proposition because of the volume of
operations involved. But during the last few years, banks seem to have realized
that the only sustainable way to increase deposits is to look at small and middle
class consumer retail deposit and not the price sensitive corporate depositors.
With financial sector reforms gathering momentum, the banking system is facing
increasing competition from non-banks and the capital market. More and more
companies are tapping the capital market directly for finance. This is one of the
main reasons for the banks to focus vigorously on the much ignored retail deposits.
Margins in corporate banking are also shrinking. In corporate lending, the margins
are generally 1 to 2 per cent above the prime rate. In retail they are 3–4 per cent.
In addition, it is reported that the Indian retail market has the potential to be
second only to the US. National Readership Survey 5 puts Indian households
Self-Instructional
238 Material
with monthly income of over 5,000 at 4.5 million. According to the survey, the Recent Trends in Indian
Banking System
category of households with annual income of 2 lakh and above is growing at the
rate of 30 per cent per annum. This obviously indicates the enormous potential of
the retail market. No wonder, banks with vision and insight are trying to woo this
market through a series of innovative additions to their products, services, NOTES
technology and marketing methods. Fixed and Unfixed Deposits (i.e., Cluster
Deposits which can be broken up into smaller units to help meet depositors needs
without breaking it up entirely), centralized database for ‘any branch banking’
(whereby a customer can access his account in any of the branches irrespective of
the branch where the account is maintained), room service (whereby the customers
are visited at their residences/offices to enable them to open their accounts),
automatic teller machines, telebanking network, extended banking time, courier
pick-up for cheques and documents, etc., are some of the privileges extended to
the customers by the banks in their eagerness to cultivate the retail market. In
short, in the bold new world of retail banking, the customer is crowned as king.
Breakthrough in Virtual Banking
Closely allied to the above point is the emergence of virtual banking. Going by the
latest indications, virtual banking is catching up in the Indian banking system. ATMs
(Automated Teller Machines) have been installed by almost all the major banks in
major metropolitan cities and even rural areas. The Shared Payment Network
System (SPNS) has already been installed in Mumbai. The operationalization of
the Very Small Aperature Terminal (VSAT) is expected to provide a thrust to the
development of Indian Financial Network (INFINET) which will further facilitate
connectivity within the financial sector. Electronics Funds Transfer (EFT) mechanism
has been initiated by major banks. As on 30 September 2001, the scheme, which
is operated by the Reserve Bank, is available for funds transfer across thirteen
major cities in the country. The scheme was originally intended for small value
transactions. However, with effect from 1 October 2001, even large value
transactions (as high as 2 crore) have also been permitted.
It may be recalled here that the EFT system was introduced in India in the
light of the recommendations of the Shere Committee, which had pointed out the
legal impediments to the establishment of the system and had advised the Reserve
Bank of India on what was to be done. The committee, while recommending a
single national level inter-bank and intra-bank funds transfer system to be introduced
immediately, said that all commercial banks in public and private sector and co-
operative banks satisfying certain criteria with particular regard to capital adequacy,
sufficiently high level of computerization and willingness to abide by the rules and
regulations should be admitted in the EFT system as participants. Regarding the
fixation of responsibilities and liabilities of the participants and bank customers,
the committee recommended that the Reserve Bank of India might be empowered
to frame the relevant regulations. The committee, after considering the various
legal implications of the system, recommended that there was the need for a new
Self-Instructional
Material 239
Recent Trends in Indian EFT Act in the long run although in the short run an EFT system might be adopted
Banking System
on a combination of regulatory and contractual models. While Section 17 (6) of
the Reserve Bank of India Act empowered the Bank to operate a remittance
system for transfer of funds, Section 58 (2) (P) of the Act empowered the Bank to
NOTES make regulations in this regard. India was lagging behind in this technological field.
But the way is now clear for electronics funds transfer which will go a long way in
curing the corporate sector’s headaches of cash management in multiple locations.
The system is a path-breaking technology that will ultimately pave the way for
paperless banking.
While technology has resulted in facilities such as ‘Total Branch Automation’,
‘Single Window Service’ and other accounts related functions in the recent past,
the thrust areas of the present relate to the use of technology for providing centralized
systems for banks where centralized data exists with decentralized access to
branches and their constituents. This would result in the customer being treated as
a customer of a bank as a whole rather than of a particular branch. The area of
Payment and Settlement Systems, which is at the core of banking activities, has
also got a shot in the arm, thanks to emerging technologies.
Thus, the banking institutions are now in a position to provide an enlarged
range of services to the customers more rapidly and accurately at their convenience
without direct physical access to bank branches.
Move towards Universal Banking: ‘Financial Services Supermarkets’
A recent trend in the Indian banking system has been the diversification of the
activities of the banks by providing a length of financial services within the banks
themselves or through the subsidiary route, thereby converting themselves into
‘financial services supermarkets’. Thus, many have entered themselves into the
field of merchant banking services, factoring services, asset management services,
insurance services, etc. In keeping with the liberalization process in the financial
system, in February 1994, banks have been allowed to undertake para banking
activities like equipment leasing, hire purchase financing and factoring. Banks have
been advised to select certain branches to undertake these activities. They can
now undertake such activities subject to an overall exposure ceiling of 15 per cent
of the bank’s capital funds to an individual borrower and 40 per cent to a group of
borrowers. It may be noted in this connection that a major step towards universal
banking has been the merger of ICICI with ICICI Bank Ltd.
From Moneylending to Development Banking
As an extension to the above, it may be noted that from being dispensers of short-
term credit, banks are now actually helping industrial development of the country
by providing access to capital market and long-term savings of the economy. The
transformation of banks from being moneylenders to development bankers is a
recent phenomenon in the Indian banking system.
Self-Instructional
240 Material
Establishment of Specialized Branches Recent Trends in Indian
Banking System
Another recent trend visible in the banking system, especially with the onset of
liberalized branch licensing policy of the Reserve Bank, has been the establishment
of specialized branches to cater to the needs of specific segments of the clientele. NOTES
The following are the main types of such specialized branches:
NRI Branches — to cater to the needs of NRI clientele.

Industrial Finance Branches — to cater to the needs of industrial clients
exclusively.
Overseas Branches — to specifically concentrate on export-
import business.
Small-scale Industries Branches — to deal with small-scale industries
exclusively.
Professional Branches — to cater to the needs of professionals such
as engineers, doctors, chartered
accountants, lawyers, contractors, etc.
Agricultural Finance Branches — to cater to the needs of high-tech
agriculture, agro exports and corporate
clients dealing with agri-business.
Recovery Branches — to exclusively concentrate on recovery of
non-performing assets.
Customer Focus
Growing expectations of the bank customers is a marked feature of the current
banking environment. Forces of competition and growth of technology are mainly
responsible for this change. At the same time, however hard a bank may try to
meet customer expectations, there will be occasions for customer complaints.
Hence, the Banking Ombudsman Scheme instituted by the Reserve Bank, discussed
in detail elsewhere, is a welcome step in the right direction. It may briefly be
pointed out here that the main objective of the scheme is to create a forum for the
speedy redressal of customers’ grievances and also to receive unresolved complaints
about the provision of banking services, as well as to facilitate the settlement or
withdrawal of such grievances.
Conclusion
The above analysis clearly indicates that it is being increasingly realized by our
banks that banking is no more a deposit taking and moneylending institution, making
profits on the differential, nor is a bank an institution which could be run by bankers
whose only qualifications were high integrity, intuitive shrewdness, certain degree
of impassivity; but not necessarily high intellect. The last few years have witnessed
profound changes in Indian banking.
Self-Instructional
Material 241
Recent Trends in Indian Since the days of social control and the nationalization of major commercial
Banking System
banks, the progress towards aligning the banking system’s operations to the needs
of our developing economy has been truly remarkable. The financial sector reforms
initiated during the recent past can rightly be considered as the second banking
NOTES revolution paving way for the development of superior foundations and positioning
the banking system strategically to meet the challenges and brace the opportunities
of the future. Of course, one is acutely aware that given the tasks and problems
before the banking system, there is still much to be done but it would be less than
charitable not to pay tribute to the progress achieved so far.
Check Your Progress

1. What has given a new orientation to the Indian banking system?
2. What is a good measure to the development of banking habitat?

QUESTIONS
1. The identification of the priority sectors for the purpose of financing by

banks has given a new orientation to the Indian banking system.
2. A good measure to the development of banking habit is provided by the
growth in the volume of banking transactions in relation to gross domestic
product.
14.4 SUMMARY
 As a rule, banking systems are adapted to the structure and needs of the
particular economy they exist in Indian economic policy has been founded
on the philosophy of economic growth with social justice.
 Banks are no longer confined to metropolitan cities and large towns.
 The branch network is extensive and these branches are now spread out
into the remote corners of our country.
 According to traditional banking theory, the creditworthiness of a person is
based on the basis of the tangible assets owned by him.
 The identification of the priority sectors for the purpose of financing by
banks has given a new orientation to the Indian banking system.
 The increasing realization of the banking system to fall in line with the socio-
economic objectives necessitated the expansion of the network of branches
to the underbanked areas of the country.
 The ‘area approach’ is another method adopted by the banking system to
Self-Instructional correct the regional imbalances in development.
242 Material
 As a natural corollary to the development in the field of branch banking, Recent Trends in Indian
Banking System
development of banking habits in India during the last few decades has
been at an unparalleled pace.
 During the recent past, the retail character of banking operations has become
NOTES
more predominant, especially among the new private sector banks.
 Another recent trend visible in the banking system, especially with the onset
of liberalized branch licensing policy of the Reserve Bank, has been the
establishment of specialized branches to cater to the needs of specific
segments of the clientele.
14.5 KEY WORDS
 Finance : Finance is a field that is concerned with the allocation (investment)

of assets and liabilities over space and time, often under conditions of risk
or uncertainty.
 Cheque: A cheque is an order to a bank to pay a stated sum from the
drawer’s account, written on a specially printed form.
 Ombudsman: The ombudsman is an independent official who has been
appointed to investigate complaints.

EXERCISES
1. What is the most striking feature of the Indian banking system?
2. What do you understand by traditional banking theory?
3. Mention some of the recent developments in the field of branch banking.
4. What is area approach?
5. How has retail banking emerged in the past?
1. What are the recent trends in the Indian banking system? Discuss.
2. ‘The identification of the priority sectors for the purpose of financing by
banks has given a new orientation to the Indian banking system.’ Comment
on the statement with reference to the text.
3. How has banking habitat developed in the recent past? Explain.
4. What is virtua banking? How has virtual banking facilitated the banking
structure?
Self-Instructional
Material 243
Recent Trends in Indian
Banking System 14.7 FURTHER READINGS

NOTES Goddard, John and Wilson O.S. John. 2016. Banking: A Very Short Introduction.
Delhi.
Self-Instructional
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BLOCK I: BASIC THEORY OF BANKING

BLOCK II: INDIAN BANKING SYSTEMS

BLOCK III: BANKS REGIONAL SET AND RRB

BLOCK IV: BANKER AND CUSTOMER SYSTEM

BLOCK I: BASIC THEORY OF BANKING

UNIT 2 UNIT AND BRANCH BANKING 9-14

UNIT 3 COMMERCIAL BANKING 15-36

UNIT 4 RESERVE BANK OF INDIA 37-53

UNIT 5 INTRODUCTION TO MONEY 54-75

BLOCK II: INDIAN BANKING SYSTEMS

UNIT 7 BANKING REGULATION 105-135

UNIT 9 STATE BANK OF INDIA 149-171

BLOCK III: BANKS REGIONAL SET AND RRB

BLOCK IV: BANKER AND CUSTOMER SYSTEM

UNIT 13 BANKER AND CUSTOMER: RELATIONSHIP 216-234

UNIT 14 RECENT TRENDS IN INDIAN BANKING SYSTEM 235-244

Banks play an inevitable role in a country’s economy. The demographics of a

1.3 KINDS OF BANKS

Fig. 1.1 Classification of Banks in India

Check Your Progress

1.4 CREDIT CREATION AND BALANCE SHEET

According to our assumption, the bank would need to maintain a cash

These deposits, now standing to the credit of the borrowers are, as we

position would be:

Check Your Progress

1.5 ANSWERS TO CHECK YOUR PROGRESS

1. Banks in India are regulated by the Banking Regulation Act, 1949.

 Banking plays a pivotal role in modern trade and commerce.

1.7 KEY WORDS

 Cheque:A cheque, or check is a document that orders a bank to pay a

NOTES Short-Answer Questions

1.9 FURTHER READINGS

Somashekar, NT. 2009. Banking. NewAge International. New Delhi.

UNIT 2 UNIT AND BRANCH Banking

2.2 UNIT BANKING AND BRANCH BANKING:

Check Your Progress

2.3 ANSWERS TO CHECK YOUR PROGRESS

2.5 KEY WORDS

NOTES Short-Answer Questions

2.7 FURTHER READINGS

Somashekar, NT. 2009. Banking. NewAge International. New Delhi.

UNIT 3 COMMERCIAL BANKING

After going through this unit, you will be able to:

3.2 FUNCTIONS OF BANKS

As we have already discussed the classification of banks and creation of credit in

A Kisan Credit Card (used to be designated as ‘green card’ by some banks)

settlement in trade. Its function is to enable a seller or exporter of goods to obtain

As part of their comprehensive banking services, many banks act as a major

Check Your Progress

3.3 INVESTMENT POLICIES

Investment banks are organizations which assist business corporations and

3.4 BANK ASSETS AND STRUCTURE

Check Your Progress

3.5 CLEARING HOUSES

Check Your Progress

3.6 ANSWERS TO CHECK YOUR PROGRESS

1. The two essential functions of a commercial bank may best be summarized

 The two essential functions of a commercial bank may best be summarized

3.8 KEY WORDS